May 2000 updates
Settlement risk is the risk that a settlement in a transfer system does not take place as expected. Generally, this happens because one party defaults on its clearing obligations to one or more counterparties. As such, settlement risk comprises both credit and liquidity risks. The former arises when a counterparty cannot meet an obligation for full value on due date and thereafter because it is insolvent. Liquidity risk refers to the risk that a counterparty will not settle for full value at due date but could do so at some unspecified time thereafter; causing the party which did not receive its expected payment to finance the shortfall at short notice. Sometimes a counterparty may withhold payment even if it is not insolvent (causing the original party to scramble around for funds), so liquidity risk can be present without being accompanied by credit risk.
One of the best ways of mitigating settlement risk is a safe and efficient payment system based on internationally accepted standards and practices. To promote such standards, the Committee on Payment and Settlement Systems issued "Core principles for systemically important payment systems" (1999). Besides the 10 core principles, the paper also outlines four responsibilities of central banks in applying these principles. (See 'Netting and Insolvency' for further discussion of the paper.)
The risk that transactions cannot be settled affects every type of asset and instrument which requires a transfer system to pass from one party to another. But as a risk it figures most prominently in currency trading because the daily settlement flows in foreign exchange clearing dwarf everything else. Historically also, the biggest problems in settlements have occurred in currency trading. The Bank for International Settlements estimates that the average daily turnover of global currencies in spot, outright forward and foreign exchange swap contracts is US$1,230 billion. Since each trade could involve two or more payments, daily settlement flows are likely to amount, in aggregate, to a multiple of this figure especially on standard expiration dates. Even more frightening, a report prepared by the Committee on Payment and Settlement Systems (CPSS) of the central banks of the G-10 countries maintains that a bank's maximum foreign exchange settlement exposure could equal, or even surpass, the amount receivable for three days' worth of trades, so that at any point in time, the amount at risk to even a single counterparty could exceed a bank's capital.
The most well-known example of settlement risk is the failure of a small German bank, Bankhaus Herstatt in 1974. On 26th June 1974, the firm's banking licence was withdrawn, and it was ordered into liquidation during the banking day; but after the close of the German interbank payments system (3:30pm local time). Some of Herstatt Bank's counterparties had irrevocably paid Deutschemarks to the bank during the day but before the banking licence was withdrawn. They had done so in good faith, believing they would receive US dollars later in the same day in New York. But it was only 10:30 am in New York when Herstatt's banking business was terminated. Herstatt's New York correspondent bank suspended all outgoing US dollar payments from Herstatt's account, leaving its counterparties fully exposed to the value of the Deutschemarks they had paid the German bank earlier on in the day. This type of settlement risk, in which one party in a foreign exchange trade pays out the currency it sold but does not receive the currency it bought, is sometimes called Herstatt risk. It is however an inappropriate term since it has materialised in other cases and under differing circumstances. The collapse of US investment bank Drexel Burnham Lambert in 1990, Bank of Credit and Commerce International the following year and Barings in 1995 are all excellent case study material for 'Herstatt' risk. The more appropriate name for 'Herstatt' risk is foreign exchange settlement or cross-currency settlement risk. The amount at risk equals the full amount of currency purchased and lasts from the time that a payment instruction (for the currency sold) can no longer be cancelled unilaterally until the time the currency purchased is received with finality (irrevocable and unconditional).
(i) Foreign Exchange
A substantial number of the Bank for International Settlement initiatives on settlement risk are on foreign exchange trading. The pre-1996 reports looked at the minimum standards of different types of domestic and cross-border payment, settlement and netting systems; and the oversight structure required for such international systems. They also examined how central banks could help decrease settlement risk by analysing the advantages and disadvantages of the different payment and settlement schemes that central banks could offer. The main studies of this era were 'Report on Netting Schemes, 1989 ' (the Angell Report), 'Report of the Committee on Interbank Netting Schemes, 1990 (the Lamfalussy Report) and "Central Bank Payment and Settlement Services with respect to Cross-Border and Multi-Currency Transactions", 1993 (Noel Report). (for more on these reports, see netting.)
A fundamental concept of the Noel report is multi-currency delivery-versus-payment (multi-DVP). Delivery-versus-payment means that the final transfer of one asset occurs if, and only if, the final transfer of an(other) asset(s) occurs. Assets could be monetary assets (such as foreign exchange), securities or other financial instruments. A multi-currency DVP system would thus eliminate Herstatt or cross-currency settlement risk. The report looks into the various ways central banks could help set up or support multi-currency DVP settlement systems such as the extension of domestic payment systems operating hours, establishing cross-border operational links between domestic payments systems or multi-currency accounts and settlement facilities provided by a central bank.
In a report released in 1996, entitled "Settlement Risk in Foreign Exchange Transactions (the Allsopp report)", the CPSS set out a three-track strategy for tackling foreign exchange settlement risk. The CPSS believes that the first step towards reducing settlement risk and containing systemic risk is for each institution to understand the nature and scope of its settlement exposures. To help banks come to grips with settlement risk, the report outlines a methodology to measure foreign exchange settlement risk and steps to shorten the time lags within the settlement process.
The CPSS divides the settlement process into five broad categories: revocable, irrevocable, uncertain, fail and settled. The bank however needs to know three critical times in its payment/receipt sequence - (i) its unilateral payment cancellation deadline, when it can no longer unilaterally cancel a payment instruction (ii) when it is due to receive with finality the currency it bought, and (iii) when it identifies final and failed receipts - before it can split its settlement exposure into the above five categories.
Appendix 2 in the report contains a summary of best practices for controlling settlement risk drawn up by The New York Foreign Exchange Committee. There are 16 recommendations, ranging from basics such as understanding the settlement process to mandating ownership of losses stemming from counterparty failure. The report warned that, unless action was taken, central banks would have to consider further regulatory steps to strengthen risk management in the foreign exchange area. The report also called upon industry groups to devise safe mechanisms for addressing settlement risk by providing risk-reducing multicurrency services.
Two years on, the CPSS released a report titled, "Reducing Foreign Exchange Settlement Risk: A Progress Report" (1998) . The committee notes that many major market participants have made great progress in dealing with foreign exchange settlement risk. Clear lines of responsibility at a senior management level have been established and firms have committed significant resources to dealing with the issue. Industry groups have got together and have been instrumental in forming a new company, CLS Services, to develop plans for a continuous linked settlement bank (CLS Bank) to settle foreign exchange deals. But the Committee warns that while much improvement has been made, 60% of banks surveyed still underestimate their exposures.
"Supervisory Guidance for Managing Settlement Risk in Foreign Exchange Transactions" (1999) is the response of the Basle Committee to the G-10 central bank governors' invitation to develop international guidance on the control of fx settlement risk. The report recommends that banks actively manage their exposures. The duration of exposures can be reduced by improving unilateral payment cancellation deadlines by, for example, negotiating better terms with correspondents and improving internal processing. The documentation covering a correspondent's service agreement should identify the latest time the correspondent can guarantee to satisfy a cancellation request. There is also a section on the role of supervisors who should expect all banks to measure fx settlement risk, set binding limits for all counterparties, monitor closely limit excesses and unusual settlement activity.
The report also called upon individual banks and industry groups to devise safe mechanisms for addressing settlement risk. Appendix 2 in the report contains a summary of best practices for controlling settlement risk drawn up by The New York Foreign Exchange Committee. There are 16 recommendations, ranging from basics such as understanding the settlement process to setting prudent exposure limits to mandating ownership of losses stemming from counterparty failure. The report warned that, unless action was taken, central banks would have to consider further regulatory steps to strengthen risk management in the foreign exchange area.
The CPSS also believes that central banks should promote real-time gross settlement systems because they reduce settlement risks by achieving finality continuously. Ten of the eleven 'Group of Ten' countries either already have real-time gross settlement (RTGS) systems or are in the process of introducing them. RTGS systems are defined as systems in which both processing and final settlement of funds transfer instructions take place continuously. Because they are so important, the CPSS set up a Study Group to identify and analyse the major issues of such systems.
Their findings are presented in "Real-Time Gross Settlement Systems (1997)" which must be on the reading list of anyone wanting to understand settlement systems. The report analyses the types and sources of payment risk, various key payment system concepts, different RTGS systems in the G-10 countries and the design and operation of a RTGS system. The latter depends on three main factors:
- whether the central bank provides intraday credit to participants in the systems, and if so, on what terms,
- the message flow structure which is affected by the role of the central bank relative to the private sector in the day-to-day operation of the system,
- the queuing facilities, if any.
(ii) Securities settlements
The crash of '87 prompted regulators to review securities settlement procedures with a view to reducing or eliminating principal risk. This is similar to cross-currency risk in foreign exchange settlements, i.e. the risk that a seller of a security could deliver a security but not receive payment, or vice versa. The CPSS concluded that the best way of eliminating principal risk was the creation of delivery-versus-payment (DVP) systems.
The three main types of DVP systems in use in G-10 countries are:
- systems that settle transfer instructions for both securities and funds on a trade-by-trade (gross) basis, with final (unconditional) transfer of securities from the seller to the buyer (delivery) occurring at the same time as final transfer of funds from the buyer to the seller (payment.)
- systems that settle securities transfer instructions on a gross basis with final transfer of securities from the seller to the buyer (delivery) occurring throughout the processing cycle, but settle funds transfer instructions on a net basis, with final transfer of funds from the buyer to the seller (payment) occurring at the end of the processing cycle.
- systems that settle transfer instructions for both securities and funds on a net basis, with final transfers of both securities and funds occurring at the end of the processing cycle.
The implications of DVP systems and their alternatives are found in "Delivery versus Payment in Securities Settlement Systems (1992)".
The DVP report was limited because it only examined securities settlements between two direct participants in a local system. With international securities trading on the increase, the CPSS decided to look also at the risks of settling internationally. "Cross-Border Securities Settlements (1995)" analyses the main channels that market participants use. These are - a local agent, a global custodian, an international central securities depository (ICSD) and using a bilateral link between central securities depositories (CSDs). The report outlines the different risks of each arrangement.
The report stresses the importance of understanding custody risks which it says will be present in any cross-border system where participants hold their securities through an intermediary, a standard practice for non-residents attempting to settle cross-border transactions. To a greater degree than is typically the case in domestic settlements, risks in cross-border settlements are concentrated in such intermediaries, especially in the ICSDs and in local agents that settle on behalf of international securities houses. The report concludes that the complexity of relationships between the multiple intermediaries poses challenges to the supervision of domestic markets and settlement systems.
Investors in emerging markets have found clearance and settlement procedures in such markets to be wanting in terms of efficiency. In 1989, the G-30 recommended that each domestic market should establish a central securities depository (CSD) to hold securities, believing that such a move would facilitate more efficient settlement procedures. In September 1996, the Emerging Markets Committee of the International Organisation of Securities Commission was asked to study the prerequisites of an efficient clearing and settlement system. In their report, "Towards a Legal Framework for Clearing and Settlement in Emerging Markets" (1997), the committee noted that the legal framework of many of these countries is still based on the concept of physical delivery which does not exist in a modern central depository system where securities are held in either immobilised or completely scripless forms, and are transferred from one party to another via book-entries. The report provides guidelines for the development of legal and regulatory policies to support automated clearing systems and central securities depositories.
(iii) Over-the-counter Derivatives
The very nature of derivatives means that there is no delivery of physical securities or principal involved. Instead they require periodic payments throughout the life of the transactions, on maturity, or both. Almost all OTC derivatives transactions are executed by telephone. Once a trade is executed, it is confirmed and settled bilaterally by the counterparties. Dealers in all the G-10 countries use master agreements (the most widely used are those developed by the Internal Swap and Derivatives Association [ISDA]) to establish the terms and conditions of OTC derivatives transactions. Master agreements provide for the netting of payment obligations in the same currency on the same value date. The most significant risk faced by OTC derivatives dealers is counterparty credit risk.
The Committee on Payment and Settlement Systems and the Euro-currency Standing Committee has published a report, "OTC Derivatives: Settlement Procedures and Counterparty Risk Management" (1998) to provide a clear understanding of existing policies and procedures for documenting, processing and settling OTC transactions. The report also identified weaknesses in the settlement process that could exacerbate counterparty risks.
An identified weakness (based on interviews with 30 leading dealers) was the existence of significant backlogs of unsigned master agreements and outstanding confirmations. For most dealers, the backlogs concerned between 5 and 20% of their counterparties, but for some the backlog was as high as 30%. To deal with this problem, most dealers had procedures in place to monitor the backlog of unsigned master agreements and to prioritise efforts to clear the backlog. The report also looked at the increased use of collateral and the potential use of clearing houses to settle OTC derivatives transactions.
See also overviews on netting and insolvency, credit risk and market integrity
- Delivery versus Payment in Securities Settlement Systems (1992)
- Cross-Border Securities Settlements (1995)
- Settlement Risk in Foreign Exchange Transactions - Allsopp report (1996)
- Real-Time Gross Settlement Systems (1997)
- Towards a Legal Framework for Clearing and Settlement in Emerging Markets (1997)
- OTC Derivatives: Settlement Procedures and Counterparty Risk Management (1998)
- Supervisory Guidance for Managing Settlement Risk in Foreign Exchange Transactions (1999)
May 2000 updates