Foreign Exchange Settlement Practices in Australia 2. Methodology

2.1 Scope

While the RBA's basic intention was to replicate the work of the CPSS in an Australian context, the coverage of its survey was more comprehensive and ambitious than those of the G10 central banks in 1995. In large part, that reflected a desire by the RBA to incorporate, in one survey, what the G10 had addressed in both initial and follow-up surveys.

As discussed above in Section 1.3, an objective of the Australian study was to ascertain whether there were any special features of the Australian foreign exchange market which would invalidate any of the general findings or the methodology of the March 1996 CPSS report. This aspect of the study was to ensure completeness only – there was no expectation that there would be any special features of the Australian market which would invalidate the general findings of the CPSS report.

2.2 Definitions and measurement

To ensure consistency of the Australian study with the G10 surveys, the RBA adopted the same definition of foreign exchange settlement exposure as the CPSS. The following explains the definitions and measurements used by the RBA, drawing heavily on sections of the CPSS report.

2.2.1 Defining foreign exchange settlement exposure

“A bank's actual exposure – the amount at risk – when settling a foreign exchange trade equals the full amount of the currency purchased and lasts from the time a payment instruction for the currency sold can no longer be cancelled unilaterally until the time the currency purchased is received with finality.” ^[1]

It is important to note that this definition is designed to address the size and duration of the credit exposure that can arise during the foreign exchange settlement process. It says nothing about the probability of an actual loss.

2.2.2 Measuring foreign exchange settlement exposure

The definition also does not specifically address the ability of a foreign exchange dealer to measure and control its settlement exposure at a particular moment. To develop a practical methodology for measuring current and future settlement exposures in a manner consistent with the above definition, a foreign exchange dealer would need to recognise the changing status – and, hence, the changing potential settlement exposure – of each of its trades during the settlement process.

Although settling a trade involves numerous steps, from a settlement risk perspective a trade's status can be classified according to five broad categories:

Status R:

Revocable. The payment instruction for the sold currency either has not been issued or may be unilaterally cancelled without the consent of the counterparty or any other intermediary. No settlement exposure exists for this trade.

Status I:

Irrevocable. The payment instruction for the sold currency can no longer be cancelled unilaterally either because it has been finally processed by the relevant payments system or because some other factor (eg internal procedures, correspondent banking arrangements, local payments system rules, laws) makes cancellation dependent upon the consent of the counterparty or another intermediary; the final receipt of the bought currency is not yet due. In this case, the bought amount is clearly at risk.

Status U:

Uncertain. The payment instruction for the sold currency can no longer be cancelled unilaterally; receipt of the bought currency is due, but the dealer does not yet know whether it has received these funds with finality. In normal circumstances, it expects to have received the funds on time. However, since it is possible that the bought currency was not received when due (eg owing to an error or to a technical or financial failure of the counterparty or some other intermediary), the bought amount might, in fact, still be at risk.

Status F:

Fail. The dealer has established that it did not receive the bought currency from its counterparty. In this case the bought amount is overdue and remains clearly at risk.

Status S:

Settled. The dealer knows that it has received the bought currency with finality. From a settlement risk perspective, the trade is considered settled and the bought amount is no longer at risk.

Diagram 1 illustrates this simplified description of the foreign exchange settlement process. To classify trades according to the categories indicated, foreign exchange dealers need to know the following three critical times for each currency that they trade:

1. the unilateral payment cancellation deadline;
2. when the currency purchased is due to be received with finality; and
3. when final and failed receipts are identified.

These times depend on the characteristics of the relevant payments systems as well as on individual dealers' internal settlement practices and correspondent banking arrangements. Nevertheless, once these times are determined and the status of each trade appropriately classified, it is a relatively straightforward calculation to measure foreign exchange settlement exposure, even in the absence of real-time information.

Dealers that always identify their final and failed receipts of bought currencies as soon as they are due can determine their exposures exactly. For these institutions, current exposure equals the sum of their Status I and F trades. In contrast, those that do not immediately identify their final and failed receipts cannot pinpoint the exact size of their foreign exchange settlement exposures. The uncertainty they face reflects their inability to know which of their Status U trades have or have not actually settled (ie they do not know the amount of bought currencies that should – but might not – have been received on time).

Faced with this uncertainty, dealers should be aware of both their minimum and maximum foreign exchange settlement exposures. The following general guidelines can be used to measure these two extremes.

Minimum exposure:

Sum of Status I and F trades. This is the value of the trades for which a dealer can no longer unilaterally stop payment of the sold currency but has not yet received the bought currency.

Maximum exposure:

Sum of Status I, F and U trades. This equals the minimum exposure plus the amount of bought currencies that should – but might not – have been received.

In compiling this report, the RBA has assessed the industry's risk profile by using maximum exposure as the benchmark. The industry's actual exposure will usually fall well short of this amount, but it is instructive for participants to know the magnitude of a potential ‘worst-case scenario’.^[2]

2.3 Sample selection

In March 1997, the RBA wrote to the chief executive officers of 24 authorised foreign exchange dealers, inviting their institutions to participate in the survey. The institutions surveyed accounted for over 90 per cent of local market turnover and included both banks and non-banks. A complete list of respondents can be found in Annex A of this report.

The top fifteen dealers, by reported turnover, were included in the sample as a matter of course. Other dealers with lower turnover volumes were selected because of their unique characteristics, such as currency trading patterns, ownership and physical location.

2.4 Data collection

Prior to writing to the chief executives, the RBA prepared a draft questionnaire and circulated this to several prospective respondents, inviting their comments. Quantitative and qualitative aspects were covered in a single survey and in this sense, as noted above, it was a more comprehensive exercise than that undertaken by the G10 central banks in 1995. The institutions consulted all offered constructive comments on the design of the survey and their assistance was very much appreciated. A copy of the final questionnaire forms Annex B of this report.

Despite this preparation, many respondents – including those that had been consulted about the design of the questionnaire – experienced considerable difficulties in completing the survey. The RBA held follow-up discussions with most respondents in order to correct obvious errors or omissions and to clarify some responses. That process, which had not been anticipated, delayed the study and the release of this report.

2.5 Industry composites

Once the obvious errors were corrected and the RBA was substantially satisfied with the quality of the data overall, it aggregated the individual responses to construct an industry composite of the risk profile of the Australian foreign exchange market. As noted above, this was done using the ‘maximum exposure’ benchmark.

In order to ensure consistency of the Australian results with those of the CPSS study, reliance was placed on weighted average measurements when compiling much of the quantitative data. For the qualitative data, however, the RBA looked for commonality in the individual responses, seeking to discern if respondents took similar approaches towards particular issues.

2.6 Caveat

Despite its best efforts, and those of the respondents, the RBA remains sceptical about certain elements of the data supplied by some institutions. However, it believes that the information detailed in this report is a fairly accurate representation, in aggregate, of the settlement practices of the broader Australian market.

Footnotes

BIS (1996), Settlement Risk in Foreign Exchange Transactions, p.8. [1]

The amounts at risk presented later in this report explicitly assume that there were no failures to settle in any currency on an average day. No information was sought from survey respondents on failed transactions and, thus, the exposures presented in Chapter 3 only measure the sum of Status I and U transactions. [2]