- SUPERVISION NEWSLETTER
Sound practices for managing FX settlement risk
17 May 2023
Volatility has increased in various markets, also because of monetary policy normalising at a different pace in different parts of the world. This has also affected foreign exchange (FX) markets and reminded us that situations in the market can rapidly change. Sound governance and proper risk management are therefore of the essence - including sound management of FX settlement risk. FX settlement risk is the risk that one party in a foreign exchange trade pays out the currency it sold but does not receive the currency it bought. This is also called Herstatt risk - named after the German Herstatt bank that failed in 1974 because of FX trading risks - and it was the reason for setting up the Basel Committee on Banking Supervision (BCBS) in the same year. While FX settlement risk is a tail risk, it remains very significant and continues to grow.
The ECB has assessed the FX settlement risk management practices of a sample of banks. The focus was on the governance arrangements as well as on the measurement, management and mitigation of FX settlement and related risks. The assessment was performed on the basis of the 2013 Supervisory guidance for managing risks associated with the settlement of foreign exchange transactions by the BCBS, also considering the FX Global Code from July 2021 that sets good practices in the foreign exchange market.
This review has enabled the ECB to identify a number of sound risk management practices that have already been shared with banks. The ECB will follow up on banks’ adherence to these practices. The main dimensions of sound FX settlement risk management are the following:
Measuring FX settlement risk
Banks’ policies and procedures must establish how FX settlement risk is measured, clearly stating the method chosen for calculating duration (in particular for principal risk). When banks account for the full period of duration, this should begin with the unilateral cancellation deadline and end with the reconciliation and investigation of failed trades. Banks using approximation methods should be able to demonstrate that they do not underestimate the risk (also under stressed conditions).
Limit setting and usage
Banks should ensure that FX settlement exposures are subject to prudent and binding limits. Limits should apply to the FX settlement amount for the full duration of days between the unilateral cancellation deadline and when the incoming payment is reconciled. FX settlement exposure should be closely monitored and updated when new deals are closed or when events (such as failed trades) cause the exposure to last longer than expected.
Management of failed trades
One important element for sound management of FX settlement risk is the adequate and prudent management of failed trades. Effective monitoring of failed transactions is crucial, as unexpected failures cause exposures to be higher than expected. In this regard, banks should be able to promptly identify failed trades and take appropriate action. Instead of removing a trade from their systems immediately after the settlement date, banks should first account for whether they indeed received the currency they bought, or whether the trade effectively failed. A failed trade represents continued exposure for the full principal value of the operation until they investigate the reasons for failure and have taken the necessary actions. Banks should thus include failed trades in their measures for current and expected exposure and continue considering them as existing exposures against the applicable limits for as long as the incident is not resolved.
Reporting and involvement of the board of directors
The board of directors should be ultimately responsible for ensuring that the institution has strong governance arrangements that require all FX settlement-related risks to be properly identified, measured, monitored, and controlled throughout the business. Banks should also have internal processes in place to ensure the regular and timely reporting of FX settlement risks to the relevant risk management function or senior management member, as appropriate. If the risk is considered material or its materiality increases, the board should receive sufficient and timely information on the risk level and management of the FX settlement risk, and should in any case be promptly informed of any serious incidents.
Internal incentives to reduce the risk
Banks should use payment versus payment (PvP) settlement to eliminate principal risk when settling FX transactions, where practicable. To fully address FX settlement risks, banks’ incentive schemes, business practices and infrastructures must be properly aligned. Banks should define effective incentives to reduce the risks associated with FX settlement, by for instance differentiating and passing on the costs to business units based on the risk profiles of their transactions, or by allocating penalties and financial costs from settlement incidents to the initiating business units. Banks could also adjust the remuneration of front office staff to take failed trades into consideration. If the trade counterparty used a settlement method that prevents banks from reducing their principal risk, they could consider decreasing their exposure limit to the counterparty or they could incentivise the counterparty to modify its FX settlement methods. In addition, where trades are settled in PvP, banks may lower their internal risk charge (economic capital) relative to traditional settlement on a gross basis.
Last but not least, the ECB expects banks to properly consider this risk in their internal capital adequacy assessment process. The quantification of own funds for FX settlement risk should comply with the Capital Requirements Regulation.