The Governors of the central banks of the Group of Ten (G-10) industrial countries have endorsed a comprehensive strategy under which the private and public sectors can together seek to contain the systemic risk inherent in current arrangements for settling foreign exchange transactions. This report, prepared by the Committee on Payment and Settlement Systems (CPSS) of the central banks of the G-10 countries, describes the strategy and presents its underlying analysis.

1.1.1 Central bank concerns

The vast size of daily foreign exchange (FX) trading, combined with the global interdependencies of FX market and payments system participants, raises significant concerns regarding the risk stemming from the current arrangements for settling FX trades. These concerns include the effects on the safety and soundness of banks, the adequacy of market liquidity, market efficiency and overall financial stability.

The risk to domestic payments systems, and to the international financial system, posed by the FX settlement process came into focus at the time of the 1974 failure of Bankhaus Herstatt. More recent examples include Drexel, BCCI, the attempted Soviet coup d'état and Barings.

1.1.2 G-10 initiatives to address concerns

In response to the Herstatt episode, the G-10 central banks began by working together on supervisory issues, including FX market risk and the need for an international early warning system. In the early 1980s, they began to study the payments systems used for the settlement of domestic and cross-border transactions, with a view to ensuring that the structures and designs of those systems did not create unacceptable interbank credit exposures and did not generate liquidity risks for the financial markets or for the national or international banking systems. It was in particular apparent that large-value cross-border payments, including those made in settlement of FX transactions, account for a large, and sometimes very large, proportion of flows through domestic payments systems, and this was seen to require detailed analysis.

The work of the G-10 central banks on international payment arrangements has produced several studies, including the February 1989 Report on Netting Schemes (the Angell Report), the November 1990 Report of the Committee on Interbank Netting Schemes (the Lamfalussy Report) and the September 1993 report on Central Bank Payment and Settlement Services with respect to Cross-Border and Multi-Currency Transactions (the Noël Report). Through these studies the central banks identified issues that may be raised by cross-border and multi-currency netting arrangements, recommended minimum standards and an oversight regime for cross-border netting schemes, and examined possible central bank service options that might decrease risk in the settlement of FX trades.

In June 1994 the CPSS formed the Steering Group on Settlement Risk in Foreign Exchange Transactions to build upon this past work and to develop a strategy for reducing FX settlement risk. In preparing its report, the Steering Group developed a definition and methodology for measuring FX settlement exposure (see Appendix 1). Using this analytical framework, the Steering Group surveyed approximately 80 banks in the G-10 countries to document current market practices for, and barriers to, managing settlement risks in a prudent manner. This work yielded the following key findings:

• FX settlement exposure is not just an intraday phenomenon: current FX settlement practices create interbank exposures that can last, at a minimum, one to two business days, and it can take a further one to two business days for banks to know with certainty that they received the currency they bought.
• Given current practices, a bank's maximum FX settlement exposure could equal, or even surpass, the amount receivable for three days' worth of trades, so that at any point in time - including weekends and public holidays - the amount at risk to even a single counterparty could exceed a bank's capital.
• Individual banks could, if they so choose, significantly reduce their own exposures and systemic risk more broadly by improving their back office payments processing, correspondent banking arrangements, obligation netting capabilities and risk management controls.
• Well-designed multi-currency services such as multi-currency settlement mechanisms and bilateral and multilateral obligation netting arrangements could greatly enhance the efforts of individual banks to reduce their FX settlement exposures.
• Some major banks are concerned about the sizable FX settlement risks they face and are actively pursuing ways to improve their own settlement practices and to collectively develop risk-reducing multi-currency services.
• Nevertheless, despite their considerable capacity to reduce FX settlement risk through individual and collective action, many banks remain sceptical about devoting significant resources to such efforts.

1.2 Summary of strategy

Overall, the G-10 central banks believe that private sector institutions have the ability, through individual and collective action, to significantly reduce the systemic risks associated with FX settlements. Accordingly, the Governors of the G-10 central banks have agreed that the following three-track strategy should be implemented:

• Action by individual banks to control their foreign exchange settlement exposures

  Individual banks should take immediate steps to apply an appropriate credit control process to their FX settlement exposures. This recognises the considerable scope for individual banks to address the problem by improving their current practices for measuring and managing their FX settlement exposures.

• Action by industry groups to provide risk-reducing multi-currency services

  Industry groups are encouraged to develop well-constructed multi-currency services that would contribute to the risk reduction efforts of individual banks. This recognises the significant potential benefits of multi-currency settlement mechanisms and bilateral and multilateral obligation netting arrangements, and the G-10 central banks' view that such services would best be provided by the private sector rather than the public sector.

• Action by central banks to induce rapid private sector progress

  Each central bank, in cooperation, where appropriate, with the relevant supervisory authorities, will choose the most effective steps to foster satisfactory private sector action over the next two years in its domestic market. In addition, where appropriate and feasible, central banks will make or seek to achieve certain key enhancements to national payments systems and will consider other steps to facilitate private sector risk reduction efforts. This recognises the likely need for public authorities to encourage action by individual banks and industry groups, and to cooperate with these groups, to bring about timely, market-wide progress.

The G-10 central banks believe that this strategy can adequately address the systemic risk inherent in current practices for settling FX transactions. Indeed, several important industry initiatives are well under way. For instance, in 1994 the New York Foreign Exchange Committee issued a report and a set of recommendations designed to help market participants reduce their FX settlement exposures (see Appendix 2). That report, and the general topic of FX settlement risk, have since received considerable attention. In addition, as described in Section 3, several risk-reducing multi-currency services are currently available in the market. These include bilateral obligation netting arrangements provided by FXNET, S.W.I.F.T. and VALUNET, and multilateral obligation netting and settlement services provided by ECHO and, prospectively, the proposed Multinet International Bank. Furthermore, the recently formed "Group of 20" banks and other private sector organisations are exploring the feasibility of establishing other multi-currency settlement services. The G-10 central banks for their part stand ready to cooperate, where appropriate and feasible, with all industry groups seeking to develop risk-reducing multi-currency settlement services.

Although any or all of these private sector efforts could play a major role in improving the current situation, they have yet to bring about a substantial and permanent reduction in FX settlement risk throughout the market. Accordingly, the G-10 central banks will closely monitor the progress of private sector action over the next two years to determine the need for further action.

To increase market awareness and understanding of foreign exchange settlement risk, Section 2 presents an overview of the topic and Section 3 summarises the results of the market survey. Section 4 describes the recommended strategy in detail and Section 5 sets out the next steps.