Understanding Risk in the FX Market
The average volume in FX Markets is around US$2 trillion, which poses a formidable challenge to developing and maintaining robust cross border currency settlement process. A robust cross-currency settlement process is therefore a need of the day. The Group of 10 (G-10) have identified issues in the riskless settlement of cross-border and multi-currency FX transactions. Thanks to their efforts, efficient settlement systems have since evolved that today try to address specific FX risks by incorporating risk mitigation processes. These provide a comfort level to the participants in global FX markets.
At its core, settlement of a foreign exchange (FX) trade requires the payment of one currency and the receipt of another. FX trading and settlement poses many forms of risk, including market risk (the risk of loss from an unfavorable exchange rate movement), replacement risk (the risk of having to replace, at current exchange rates, an unsettled yet profitable FX transaction with a failed counterparty) and operational risk (the risk of incurring interest charges or other penalties for misdirecting or otherwise failing to make FX settlement payments on time owing to an error or technical failure). However it is the settlement risk that most needs to be addressed. The dollars involved in settlement risk are huge – a large bank has almost three times the exposure to settlement risk that it has to credit risk.
A bank’s actual exposure – the amount at risk – when settling a foreign exchange trade equals the full amount of the currency purchased and lasts from the time a payment instruction for the currency sold can no longer be cancelled unilaterally, until the time the currency purchased is received with finality. Source BIS – CPSS
This principal risk in the settlement of foreign exchange transactions is variously called foreign exchange settlement risk or cross-currency settlement risk.
FX settlement risk clearly has a credit risk dimension – whenever a party cannot make its payment of the currency it sold conditional upon its final receipt of the currency it bought, it faces the possibility of losing the full principal value involved in the transaction. In this situation, a party’s foreign exchange settlement exposure (the size of its credit exposure to its counterparty when settling an FX trade) equals the full amount of the purchased currency.
FX settlement risk also has a liquidity risk dimension – if a party does not receive the currency it purchased when it is due, it would need to cover and finance this shortfall until its counterparty honored its obligation. In fact, this liquidity risk is present even if, in this circumstance, a party could withhold its payment of the currency it sold (i.e. liquidity risk can be present even in the absence of credit risk). Thus, whether viewed from a credit or a liquidity perspective, the amount potentially at risk in settling an FX trade equals the full value of the purchased currency.
The FX market is also unique in comparison to other financial markets in that it is a 24-hour market. The final settlement of a currency is effected in the financial centre of that currency’s home country. For instance the final settlement of the US dollars happens in New York as the final settlement of pounds sterling happens in London. Differing time zones, market open and close timings, settlement deadlines in various geographies emanate another risk called the Herstatt risk. Due to time zone differences, several hours can elapse between a payment being made in one currency and the offsetting payment being made in another currency. Between these times, a counterparty may have paid in funds, before it receives funds the counterparty defaults.
It is becoming increasingly difficult for banks to manage multi-currency liquidity in real-time and co-ordinate liquidity management with the banks’ treasury functions in their domestic currency. One of the outcomes of the G-10 studies in relation to risks involved in cross border and multi currency FX settlement and their recommendations is the setting up of the CLS Bank that provides the continuous liked settlement system (CLS). CLS essentially allows a significant portion of the world’s foreign exchange transactions to be settled on a payment versus payment (PVP) basis, thereby eliminating settlement risk. PVP is a mechanism in a foreign exchange settlement system that ensures that a final transfer of one currency occurs if, and only if, a final transfer of the other currency or currencies takes place. This introduces a far higher degree of certainty in the settlement process which will benefit the market as a whole. PVP is established by the simultaneous exchange of value between settling parties. CLS settlement is not a guaranteed settlement and it only ensures that the settlement happens on a PVP basis.
The CLS Bank works on a tiered membership, with about 51 major international banks operating as direct ‘settlement members’ of CLS. These settlement members can settle both their own deals as well as deals offered by the third parties who participate through them. The settlement process is spread over a five-hour period (from 07:00 to 12:00 C.E.T) on a gross basis though the funding is on net basis in each currency. Payments are netted, so each participant in the system only has to make one net payment per currency each day.
FX Clearing houses have traditionally helped in addressing settlement risks wherein one of the currency pairs is the local currency. Local FX Clearing houses have always acted as a central counterparty giving netting as well as funding benefits to market participants by integrating their settlement systems with the Systemically Important Payment System (SIPS) of the country.
Domestic or local FX clearing houses/corporations can extend the benefits of cross border and multi-currency settlement to their customers (typically local banks and other institutions) that are not settlement members of the CLS Bank by availing the third party membership of CLS Bank/settlement members. The local banks technically become fourth party members in the settlement system.
The domestic/local clearing house’s settlement of its fourth party customers’ trades exposes the clearing house to the same kind of risks that the settlement members are exposed to. To take care of such risks, settlement banks usually set limits for all entities settling through them.
In order to address FX settlement risks, the settlement member imposes various limits on its third party participants. Typical limits are currency short position limit and aggregate short position limit (expressed in US$).
As a settlement agency of the participating fourth parties, the clearing house does not take any clean exposure on its members. Risk management processes at the clearing house are designed in such a way that the clearing house’s exposure to a member on account of its outstanding trades of the member is covered through collateral or bank guarantees. The settlement member/CLS Bank fixes short position limits on participating third parties (clearing houses) that are high enough to cover the trading levels of all the fourth party member banks whose deals are settled by the clearing house. The sub limits for the fourth party member banks are set by the clearing house. The clearinghouse may further control these sub-limits by access to individual bank’s trade information. The clearinghouse may advise the individual limits of the fourth party member banks to its settlement member. The clearing house typically has discretion to process a deal of a fourth party bank that breaches its exposure limits based on the collaterals placed with it. The settlement member bank pays off the amounts in different currencies up to the short position limits allotted to the individual participating fourth party banks. Based on the third party membership agreements between the settlement member and the clearing house and further risk management precautions taken by the clearing house, the settlement member may even pre-fund for any shortages in the account of the clearing house. It may happen that the clearing house’s account with the settlement member can end up with an overdraft in a particular currency due to non funding by a fourth party bank. However, the funds to be paid out to that bank will eventually be paid out to the clearing house account by CLS Bank. The clearing house can block this payout and make good the overdraft to the settlement member. The price risk of the clearing house nonetheless remains. To cover this risk, the clearing house may choose to impose a separate margin on the fourth party banks. This may be computed by fixing a margin factor for each currency depending upon the currency volatilities.
Since CLS Bank accepts TOM trades in addition to spot and forward trades for settlement, clearing houses may use a two day holding period in value at risk (VaR) calculated at 99% confidence level by using the Historical Simulation Method. A volatility margin may thus be imposed based on the VaR so computed. Mark to market margin may also be imposed on forward trades, to cover the exposure during the time difference between entering into the trade and the resultant settlement as compared to TOM trade. In addition, margin call also may be required if volatility in a particular currency goes beyond the VaR prescribed. Since the CLS settlement is on PVP basis (self collateralisation) the clearing house may not insist on a separate collateral.
The following diagram gives a bird’s eye view of the role of the clearing house in FX CLS settlement:
The settlement bank levies fees and other charges on its third party members. Smaller banks with lesser volume of cross-currency transactions find it unviable. Members are also required to maintain multicurrency account with settlement bank. The Clearing House maintains a single multicurrency account with the settlement bank. Together the clearing house may be able to operate in a more cost effective and efficient manner and can help share this benefit of higher volumes and bargaining power with its fourth party member banks vis-à-vis individual banks opening separate accounts.