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Trading and Capital-Markets Activities Manual

Counterparty Credit Risk and Settlement Risk 
Source: Federal Reserve System 
(The complete Activities Manual (pdf format) can be downloaded from the Federal Reserve's web site)

Settlement risk is the risk of loss when an institution meets its payment obligation under a contract (through either an advance of funds or securities) before its counterparty meets a counterpayment or delivery obligation. Failures to perform at settlement can arise from counterparty default, operational problems, market liquidity constraints, and other factors. Settlement risk exists for any traded product and is greatest when delivery is made in different time zones. For banking institutions, foreign-exchange (FX) transactions are, perhaps, the greatest source of settlement-risk exposure. For large, money-center institutions, FX transactions can involve sizable credit exposures amounting to tens of billions of dollars each day. Accordingly, although the following general guidance can be applied to the settlement of all types of traded instruments, it focuses primarily on the settlement risks involved in FX transactions. 

Settlement risk has a number of dimensions that extend beyond counterparty credit risk to include liquidity, legal, operational, and systematic risks. Even temporary delays in settlement can expose a receiving institution to liquidity pressures if unsettled funds are needed to meet obligations to other parties. Such liquidity exposure can be severe if the unsettled amounts are large and alternative sources of funds must be raised at short notice in turbulent or unreceptive markets. In an extreme example, the financial failure of a counterparty can result in the loss of the entire amount of funds. 

As with other forms of credit risk, settlement risk should be managed through a formal and independent process with adequate senior management oversight and should be guided by appropriate polices, procedures, and exposure limits. Measurement systems should provide appropriate and realistic estimates of the settlement exposures and should use generally accepted measurement methodologies and techniques. The development of customer credit limits and the monitoring of exposures against those limits is a critical control function and should form the backbone of an institution's settlement-risk-management process. 

This section discusses settlement risks involved in trading activities, especially as they apply to FX transactions. A primary reference for this material is the 1996 report of the Committee on Payment and Settlement Systems of the central banks of the Group of Ten Countries, ''Settlement in Foreign Exchange Transactions,'' which was prepared under the auspices of the Bank for International Settlements. In addition, the Board issued a policy statement, effective January 4, 1999, that addresses risks relating to private multilateral settlement systems (63 FR 34888, June 26, 1998). 


An institution's process and program for managing its settlement risks should be commensurate with the range and scope of its activities. Institutions with relatively small trading operations in noncomplex instruments may not need the same level of automated systems, policies, and staff skills as do firms that are heavily engaged in FX transactions and other trading activities. 

The management of settlement risk should begin at the highest levels of the organization, with senior management exercising appropriate oversight of settlement exposures. Although the specific organizational approaches may vary across institutions, managing settlement risk for FX and other trading activities should be integrated into the overall risk management of the institution to the fullest extent practicable. Settling transactions can involve many different functional areas of an institution, including trading, credit, operations, legal, risk assessment, branch management, and correspondent relations. Only senior management can effect the coordination necessary to define, measure, manage, and limit settlement risks across such varied functions. Accordingly, senior management should ensure that they fully understand the settlement risks incurred by the institution and should clearly define lines of authority and responsibility for managing these risks so that priorities, incentives, resources, and procedures across different areas can be structured to reduce exposures and mitigate risks. Staff responsible for all aspects of settlement-risk management should be adequately trained.

Measuring FX Settlement Exposures 

Settlements generally involve two primary events: the transmission of payment orders and the actual advance or receipt of funds. In FX transactions, it is important to distinguish a payment order, which is an instruction to make a payment, from the payment, which involves an exchange of credits and debits on the accounts of a correspondent bank or the accounts of a central bank when an interbank transfer takes place. To avoid paying late delivery fees, banks try to send their orders to their back office, branch, or correspondent bank on the day of trade or the next day. Since spot FX transactions generally call for settlement on the second day after the trade, orders are transmitted one or two days before settlement. On settlement day, payment orders are routed to the receiving institution through its correspondent or through the domestic payment system for actual final payment. Final payment may also be made through book-entry transfer if the two trading banks use a common correspondent. 

A bank's settlement exposure runs from the time that its payment order for the currency sold can no longer be recalled or cancelled with certainty and lasts until the time that the currency purchased is received with finality. In general, book-entry payments provide somewhat greater flexibility in terms of the ability to cancel a transfer because their processing does not rely on domestic payment systems. However, even the cancellation of book-entry transfers is still subject to restrictions presented by an institution's internal processing cycles and communication networks as well as time zone differences between branch locations. In theory, institutions may retrieve and cancel payment orders up until the moment before the funds are finally paid to a counterparty. However, many institutions have found that operational, economic, and even legal realities may result in payment orders becoming effectively irrevocable one or two business days before settlement day. 

Institutions should specifically identify the actual time past which they can no longer stop a payment without the permission of a third party. This time is termed the unilateral cancellation deadline and should be used as a key parameter in assessing settlement-risk exposure. The documentation covering a correspondent's service agreement generally identifies these cut-off times. In the event of a dispute, a correspondent is likely to use the contractually agreed-upon unilateral cancellation deadline as a binding constraint. 

The effect of an institution's internal processing patterns on its settlement risk should also be considered. The interval from the unilateral cancellation deadline for sold currency until final receipt of bought currency is generally referred to as the period of irrevocability. The full face value of the trade is at risk and the exposure on this amount can last overnight and up to one or two full days. If weekends and holidays are included, the exposure can exist for several days. The total exposures outstanding during this interval constitutes an institution's minimum FX settlement exposure. 

The process of reconciling payments received with expected payments can also be a significant source of settlement-risk exposure. Many institutions may not perform this exercise until the day after settlement. During this interval, there is uncertainty as to whether the institution has received payments from particular counterparties. This period of uncertainty can create increased exposure, if it extends past the unilateral cancellation deadline for payments on the following day. For example, if an institution is subject to a unilateral cancellation deadline of 3:00 a.m. on settlement day and payments from the prior day's settlements are not reconciled until mid-morning on the day following settlement, it may be too late to manage its payments exposure for that following day. In this case, the maximum exposure from the evening of settlement day to morning on the following day can amount to both the receipts expected on settlement day (since their receipt has not been reconciled) and the entire amount of the following day's settlements (since they cannot be recalled.) In effect, an estimation of worst-case or maximum settlement exposures involves adding the exposures outstanding during the period of irrevocability to the exposures outstanding during the period of uncertainty. In a worst-case situation, a bank might find itself in the position of having sent out payments to a counterparty on one day when it had not been paid on the previous day. 

Many institutions commonly define and measure their daily settlement exposures as the total receipts coming due that day. In some cases, this technique may either understate or overstate exposures. Simple measures using multiples of daily receipts can also incorrectly estimate risk. For example, using simple ''rules of thumb'' of two or three days of receipts may not sufficiently account for the appropriate timing of the settlement processing across different currencies. Appropriately measuring FX settlement exposures requires an institution to explicitly identify both the unilateral cancellation deadlines and the reconciliation process times involved in each type of currency transaction. Accordingly, any simple rules used to measure settlement exposures should be devised in such a way as to consider both the unilateral cancellation deadlines and the reconciliation process involved in settlement. Identifying the duration of the settlement process and the related exposures does not require real-time tracking of all payments and can be accomplished through estimations based on standard settlement instructions and an understanding of the key milestones in the settlement process. Institutions should have a clear means of reflecting this risk in their exposure measurements. 

Explicit consideration of unilateral cancellation deadlines and the reconciliation process can help an institution identify areas for improvement. If the time from its unilateral cancellation deadline to reconciliation can be reduced to under 24 hours, then an exposure measure of one day's receivables may provide a reasonable approximation of the duration and size of the settlement exposure to a counterparty. However, even then it must be recognized that overnight and weekend exposure may remain and that different currency pairs may require different intervals, which might overlap. 


Institutions should ensure that settlement exposures to counterparties are properly limited. FX settlement exposures should be subject to an adequate credit-control process, including credit evaluation and review and determination of the maximum exposure the institution is willing to take with a particular counterparty bank. The process is most effective when the counterparty's FX settlement exposure limit is subject to the same procedures used to devise limits on exposures of similar duration and size to the same counterparty. For example, in cases where the FX settlement exposure to a counterparty lasts overnight, the limit might be assessed in relation to the trading bank's willingness to lend fed funds on an overnight basis. 

Examiners should verify that the firm has set up separate pre-settlement and settlement lines for counterparties. Settlement exposures may also be broken down into sublimits by product. Sublimits may also be specified by date since settlement risk tends to be highest on the date of settlement. 

Effective monitoring of exposures is crucial to the management of settlement risk, and institutions with large settlement exposures should strive to monitor payment flows on a real-time basis. Institutions should look to reduce settlement risk by arranging with their correspondents and counterparties to minimize, as much as practicable, the timing of an exchange of payments. Collateral arrangements and net settlement agreements are also important settlement-risk-management tools. 

The timely reconciliation of nostro accounts also helps to mitigate settlement risk. Institutions often assume they have settlement exposure until they can confirm final receipt of funds or securities. Timely reconciliation enables an institution to determine its settlement exposure accurately and make informed judgments about its ability to assume additional settlement risk. 


From time to time, institutions may misdirect their payments, and funds may fail to arrive in promptly. While such mistakes may be inadvertent and corrected within a reasonable time, institutions should have procedures for quickly identifying fails, obtaining the funds due, and taking steps to avoid recurrences. Some institutions deduct fails from counterparty limits and review a series of fails to determine whether their pattern suggests that the problem is not procedural. 


Banks can reduce the size of their counterparty exposures by entering into legally binding agreements for the netting of settlement payments. (Netting of payment obligations should not be confused with the more common netting of mark-to-market credit exposures of outstanding contracts such as swaps and forward FX.) Common arrangements involving bilateral netting of settlement flows, including FXNet, ValueNet, and Swift Accord, and bilateral agreements following IFEMA or other contracts. Legally binding netting arrangements permit banks to offset trades against each other so that only the net amount in each currency must be paid or received by each bank to its netting counterparts. Depending on trading patterns, netting can significantly reduce the value of currencies settled. Netting also reduces the number of payments to one per currency either to or from the counterparty. 

Netting is most valuable when counterparties have a considerable two-way flow of business. As a consequence, netting may only be attractive to the most active institutions. To take advantage of risk-reducing opportunities, institutions should have a process for identifying attractive netting situations that would provide netting benefits that outweigh the costs involved. 

Some banks use the procedure of informal payment netting. Based on trading patterns, back offices of each counterparty will confer by telephone on the day before settlement and agree to settle only the net amount of the trades falling due. Since there may not be a legal opinion underpinning such procedures, institutions should ensure that they develop a good understanding of their ability to manage the legal, credit, and liquidity risks of this practice. 

Multilateral Settlement Systems 

The use of multilateral settlement systems by institutions raises additional settlement risks insofar as the failure of one system participant to settle its obligations when due can have credit or liquidity effects on participants that have not dealt with the defaulting participant. The Board's recent Policy Statement on Privately Operated Multilateral Settlement Systems provides guidance on the risks of these systems. 

The policy statement applies to systems with three or more participants that settle U.S. dollar payments with an aggregate gross value of more than $5 billion on any one day. However, the principles set forth in the policy statement can be used to evaluate risks in smaller systems. The policy statement addresses the credit, liquidity, operational, and legal risks of multilateral settlement systems and provides risk-management measures for consideration. The policy statement is intended to provide a flexible, risk-based approach to multilateral settlement system risk management and should not be interpreted as mandating uniform, rigid requirements for all systems under its purview. 

Risk-management measures to mitigate credit risk include monitoring participants' financial condition; setting caps or limits on some or all participants' positions in the system; and requiring collateral, margin, or other security. To mitigate liquidity risk, institutions operating multilateral settlement systems may also consider external liquidity resources and contingency arrangements. Liquidity risk also is mitigated by timely notification of settlement failures to enable participants to borrow funds to cover shortfalls. Operational risks are mitigated by contingency plans, redundant systems, and backup facilities. Legal risks are mitigated by operating rules and participant agreements, especially when transactions are not covered by an established body of law. 

Large multilateral settlement systems also must meet the more comprehensive requirements of the Lamfalussy Minimum Standards established by the central banks of the Group of Ten countries. Under the policy statement, in determining whether a system must meet the Lamfalussy Minimum Standards, the Board will consider whether the system settles a high proportion of large-value interbank or other financial market transactions, has very large liquidity exposures that have potentially systemic consequences, or has systemic credit exposures relative to the participants' financial capacity. 

Contingency Planning 

Contingency planning and stress testing should be an integral part of the settlement-risk-management process. Contingencies should be established to span a broad spectrum of stress events, ranging from internal operational difficulties to individual counterparty defaults to broad market-related events. Adequate contingency planning in the FX settlement-risk area includes ensuring timely access to key information such as payments made, received, or in process; developing procedures for obtaining information and support from correspondent institutions; and well-defined procedures for informing senior management about impending problems. 

Internal Audit 

Institutions should have in place adequate internal audit coverage of the settlement areas to ensure that operating procedures are adequate to minimize exposure to settlement risk. The scope of the FX settlement internal audit program should be appropriate to the risks associated with the market environment in which the institution operates. The audit frequency should be adequate for the relevant risk associated with the FX settlement area. Most institutions base audit frequency on a risk-assessment basis, and examiners should consult with the internal audit examiner to determine the adequacy of the risk-assessment methodology used by the institution. 

Audit reports should be distributed to appropriate levels of management, who should take appropriate corrective action to address findings pointed out by the internal audit department. Audit reports should make recommendations for minimizing settlement risk in cases where weaknesses are cited. Management should provide written responses to internal audit reports, indicating its intended action to correct deficiencies where noted. 

When audit findings identify areas for improvement in the FX settlement area, other areas of the institution on which this may have an impact should be notified. This could include credit-risk management, reconciliations/accounting, systems development, and management information systems. In automated FX settlement processing, the internal audit department should have some level of specialization in information technology auditing, especially if the institution maintains its own computer facility. 

Management Information Systems 

In larger, more complex institutions, counterparty exposures and positions can run across departments, legal entities, and product lines. Institutions should have clearly defined methods and techniques for aggregating exposures across multiple systems. In general, automated aggregation produces fewer errors and a higher level of accuracy in a more timely manner than manual methods. The institution should have a contingency plan in place to ensure continuity of its FX settlement operations if its main production site becomes unusable. This plan should be documented and supported by contracts with outside vendors, where appropriate. The plan should be tested periodically.

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