* Settlement Risk—A Form of Credit Risk
It was noted in Chapter 2 that foreign exchange trading is subject to
a particular form of credit risk known as settlement risk or Herstatt
risk, which stems in part from the fact that the two legs of a foreign
exchange transaction are often settled in two different time
zones,with different business hours. Also noted was the fact that
market participants and central banks have undertaken considerable
initiatives in recent years to reduce Herstatt risk. Two such efforts
are worth mentioning.
In October 1994, the New York Foreign Exchange Committee, a private-
sector group sponsored by the Federal Reserve Bank of New York,
published a study entitled Reducing Foreign Exchange Settlement Risk,
which examined the problem of settlement risk from a broad
perspective. The Committee found that foreign exchange settlement risk
is much greater than previously recognized and lasts longer than just
the time zone differences in different markets. In the worst case, a
firm can be "at risk" for as long as 72 hours between the time it
issues an irrevocable payment instruction on one leg of the
transaction and the time payment is received irrevocably and
unconditionally on the other leg. The Committee recommended a series
of private sector "best practices" to help reduce Herstatt risk,
including establishing arrangements to net payments obligations,
setting prudent exposure limits, and reducing the time taken for
reconciliation procedures.
More recently, in March 1996, the central banks of the major
industrial nations issued a report through the Bank for International
Settlements, called Settlement Risk in Foreign Exchange Transactions,
which highlighted the pervasive dimensions of settlement risk,
expressed concern about the problem, and suggested an approach for
dealing with it. The report confirmed the finding of the New York
Foreign Exchange Committee that foreign exchange settlement exposure
can last up to several days, and it recommended a three-track strategy
calling for:
* individual banks to improve management and control of their foreign
exchange settlement exposures;
* industry groups in the private sector to provide services that will
contribute to the risk reduction efforts of individual banks; and
* central banks to improve national payment systems and otherwise
stimulate appropriate private sector actions.
Some steps have been taken to reduce settlement risk, and others are
being considered to help deal with this problem. There are "back-end"
solutions, using netting and exchange clearing arrangements to modify
the settlement process, and "front-end" solutions, which change the
nature of the trade at the outset, modifying what is to be exchanged
at settlement. (See Box 8-1.)
Steps have also been taken to improve central bank services in order
to reduce foreign exchange settlement risk. At the beginning of 1998,
the Federal Reserve extended Fedwire operating hours. Fedwire is now
open 18 hours a day. Its operational hours overlap with the national
payment systems in all other major financial centers around the world.
Similarly, CHIPS has expanded its hours and introduced other
improvements.
* Sovereign Risk—A Form of Credit Risk
Another element of credit risk of importance in foreign exchange
trading is sovereign risk—that is, the political, legal, and other
risks associated with a cross-border payment. At one time or another,
many governments have interfered with international transactions in
their currencies. Although in today's liberalized markets and less
regulated environment there are fewer and fewer restrictions imposed
on international payments, the possibility that a country may prohibit
a transfer cannot be ignored—the United States Government has imposed
such restrictions on various occasions. In order to limit their
exposure to this risk, banks and other foreign exchange market
participants sometimes establish ceilings for individual countries,
monitor regulatory changes, watch credit ratings, and, where
practicable, obtain export risk guaranties and other forms of
insurance.
* Group of Thirty Views on Credit Risk
As with market risk, the management of credit risk has become more
complicated and more sophisticated with the development of derivative
instruments and, more generally, the evolution of financial markets.
The Group of Thirty report, Derivatives: Practices and Principles,
addressed questions of measuring, monitoring, and managing credit risk
in derivatives activity. The report recommended that each dealer and
end-user of derivatives should assess the credit risk arising from
derivatives activities based on frequent measures of current and
potential exposure against credit limits. It further recommended that
dealers and end-users use one master agreement as widely as possible,
and that each counterparty document existing and future derivatives
transactions, including foreign exchange forwards and options, and
cover various types of "netting" arrangements. The report also
recommended that regulators and supervisors recognize the benefits of
netting arrangements and encourage their wider use.
More recently, other ideas have been put forward for a portfolio
approach to credit risk, similar to the value-at-risk approach to
market risk. The aim would be to produce a single number for how much
a bank stands to lose on a portfolio of credits of varying
characteristics, and thus to determine how much the bank should hold
in reserve against that portfolio.
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