BIS Quarterly Review, September 2008
How FX settlement risk arises

1 September 2008

by Robert Lindley

(Extract from page 55 of BIS Quarterly Review, September 2008)

An example of how settlement risk arises when using traditional correspondent banking

In this example, Bank A has a spot trade with Bank B in which it is selling yen for US dollars. The trade is executed on Day V -2 for settlement on Day V (value day).

After the trade has been struck, Bank A sends an instruction to its correspondent in Japan (Bank Ja), asking the latter to send the yen to Bank B's correspondent there (Bank Jb) on Day V. Bank Ja executes this instruction sometime during Day V by debiting the account that Bank A holds with it and sending the yen to Bank Jb via the relevant payment system. After Bank Jb has received the funds, it credits them to Bank B's account and informs Bank B that they have arrived.

In parallel, Bank B settles its side of the trade by a similar process in which it instructs its correspondent in the United States (Bank Ub) to send US dollars to Bank A's correspondent there.
Settlement risk arises because each counterparty may pay the currency it is selling but not receive the currency it is buying. The underlying cause is the lack of any "link" between the two payment processes (in yen and dollars) to ensure that one payment takes place only if the other also does.

• Looking at the trade from Bank A's point of view, its exposure to settlement risk starts when it can no longer be certain that it can cancel its instruction to pay Bank B. This depends primarily on any agreement between Banks A and Ja about cancellation. In the absence of a specific agreement, Bank A cannot be certain whether it can cancel or not and so its exposure begins immediately it has sent the payment instruction to Bank Ja, which is likely to be on Day V -1 or even V -2. Even if there is a specific agreement, Bank Ja may need some time to process a cancellation request by Bank A, so the exposure may start at least several hours before the yen payment system opens on Day V. The effective cancellation deadline may therefore be very early on V or even on V -1 in Japanese local time, which, if Bank A is located in (say) Europe, will be even earlier in Bank A's local time because of time zone differences.
• Bank A's exposure ends when Bank Ua credits its account with the dollars received from Bank Ub. Bank Ua may not receive the funds until just before the close of the relevant payment system, and it may be some time after that that the funds are credited to Bank A's account. This could be relatively late on Day V in US local time, and even later on Day V or even on Day V +1 in the local time of Bank A. Bank A's actual exposure to this trade could therefore last more than 24 hours.

Bank B also faces settlement risk. Its exposure period will differ from that of Bank A to the extent that Banks B, Ub and Jb have different arrangements compared to those of Banks A, Ja and Ua, and the relevant US and Japanese payment systems have different opening hours. Time zone differences are also important. In this trade, time zones work against Bank A because it is selling a currency that settles in an early time zone (so it is committed to selling its currency relatively early) and buying one that settles in a late time zone (so it will receive the currency it is buying relatively late), which extends the duration of its exposure. Conversely, the time zone difference works in Bank B's favour. However, it is important to note that the problem does not arise solely because of time zone differences.