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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).
SETTLEMENT-RISK-MANAGEMENT ORGANIZATION
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.
Limits
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.
Procedures
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.
Netting
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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