Foreign Exchange Settlement Practices in Australia 1. Introduction

1.1 Background

In 1995, the central banks of the Group of Ten (G10) countries^[1] surveyed approximately eighty major banks in their respective local markets in order to document the practices used for settling foreign exchange transactions and to identify the associated risks. The G10 surveys were collated by the Committee on Payment and Settlement Systems (CPSS) of the Bank for International Settlements (BIS) and the findings were published in a report issued by the CPSS in March 1996.

That report, Settlement Risk in Foreign Exchange Transactions, did much to improve understanding of the problem and highlighted its scale. It showed that foreign exchange settlement risk is more than just an intra-day phenomenon: existing settlement practices create interbank exposures which can last anywhere from one to three or more business days. The CPSS also found that a bank's maximum foreign exchange settlement exposure could equal or even surpass the amount receivable for three days' worth of foreign exchange trades. With global turnover in excess of US$1.2 trillion each day, the accumulated amount at risk at any point in time, to even a single counterparty, could easily exceed a bank's total capital resources.

In addition to revealing the size of the problem, the CPSS also showed how banks could take measures to reduce their exposures to foreign exchange settlement risk. These measures include improving back office processes, revisiting correspondent banking arrangements, examining the scope for bilateral or multilateral netting of foreign exchange settlements and the use of other risk management techniques.

The CPSS favoured a private sector solution, with inducements given to individual banks and industry groups. However, the G10 central banks, through the CPSS, also undertook to closely monitor progress over the ensuing two-year period to mid 1998 and to assess the need for further action at that time.

1.2 The Australian foreign exchange market

As noted above, the CPSS study covered the G10 countries and currencies and therefore did not include Australia or the Australian dollar (AUD). According to the last BIS survey of activity in global foreign exchange markets, which was conducted in April 1995, the Australian market ranked ninth in terms of global turnover, while the AUD was the eighth most actively traded currency. Given this relative importance, apart from the prudential issues, it is also critical to the competitive position of both the Australian foreign exchange market and the AUD that Australian settlement and risk management practices are not out of line with world best practice.

1.3 Objectives of a study by the Reserve Bank of Australia

Both the AUD and the Australian market play an important role in the global foreign exchange market place; this is reflected by their respective turnover volumes. Furthermore, the Australian market is the first major world market to open each day and has a 14 to 16 hour time zone difference with that of the United States, whose currency is the one against which most foreign exchange transactions are conducted. Time zone differences are one major factor that determine exposure to foreign exchange settlement risk.

However, as noted above, neither the AUD nor the Australian market have been included in any of the major studies of foreign exchange settlement risk to date. Accordingly, the Reserve Bank of Australia (RBA) undertook its own study, based on the work of the CPSS.

The RBA study aimed to address the following issues:

• whether there are any special features of the Australian market which would invalidate any of the general findings or methodology of the March 1996 CPSS report;
• whether participants in the Australian market are operating at world best practice in managing their exposures to foreign exchange settlement risk;
• what are the implications of settlement practices in Australia for domestic and offshore traders of the AUD; and
• how best to ensure that the AUD and the Australian market are part of any global solution to foreign exchange settlement risk.

1.4 Outline

This report has six main chapters:

• This first chapter describes the background and objectives of the RBA survey.
• Chapter 2 outlines the methodology of the study and provides information on the definitions used and the measurements applied.
• Chapter 3 presents the major findings of the study, including the duration and magnitude of foreign exchange settlement exposure.
• Chapter 4 provides analysis of the settlement risk profile for foreign exchange transactions that involve the AUD.
• Chapter 5 examines qualitative aspects of the study, with an emphasis on the techniques that are being applied to manage foreign exchange settlement risk.
• Chapter 6 discusses the next steps and conclusions.

There are five annexes, which provide supplementary information.

Footnote

The Group of Ten countries are Belgium, Canada, France, Germany, Italy, Japan, the Netherlands, Sweden, Switzerland, the United Kingdom and the United States. [1]