Foreign Exchange Settlement Practices in Australia 5. Risk Management Practices

5.1 Introduction

Section III of the RBA questionnaire sought an open-ended discussion from respondents on the risk management practices that they employ when settling foreign exchange transactions. It canvassed views on how risks in individual institutions could be reduced and what respondents thought of overseas initiatives to minimise foreign exchange settlement risk. Naturally, there was a diverse range of experiences and opinions, but there were also some common themes arising from the responses.

5.2 Measurement issues

The CPSS proposed a methodology by which foreign exchange dealers could measure and track their exposure to settlement risk, both against individual counterparties and in aggregate. As noted earlier in Section 2.2, that methodology was used by the RBA in this report to analyse the collective exposure of the Australian market to foreign exchange settlement risk. To ensure that the industry was comfortable with the approach taken, comments were sought from survey respondents on the methodology proposed by the CPSS and its applicability to their own business operations.

Of those institutions that made comments on the CPSS report, all agreed the methodology adopted was valid and accurate. Many had not explicitly considered the changing status of a transaction – from ‘revocable’ to ‘irrevocable’ through to ‘uncertain’ and finally to ‘settled’ or ‘failed’ – but noted that the CPSS methodology provided a useful framework for analysing settlement risk on foreign exchange transactions.

However, while respondents agreed, in principle, with the methodology proposed, many expressed doubts as to whether it could be applied successfully within their own organisations. Several cited systems constraints, arguing that to apply such procedures for each counterparty, and the trading book as a whole, would be onerous. Many have made a conscious decision to fix their exposure periods in terms of days, not hours, and questioned whether the large amount of automation that would be required to constantly track the changing status of transactions could be justified.

5.3 Risk management techniques

Survey respondents were asked to describe the risk management techniques that they employ, or which they are considering, for the settlement of foreign exchange transactions. The RBA sought specific responses on the arrangements used to set counterparty limits and net foreign exchange settlements, but respondents were free to discuss other risk management techniques as well. The following sections review the risk management techniques used in the Australian market.

5.3.1 Counterparty exposure limits

All respondents, with one exception, indicated that they set limits on the amount of settlement exposure to any individual counterparty. For the most part, counterparty exposure limits are applied to the global operations of the dealers surveyed; some of the respondents which are branches or subsidiaries of foreign banks indicated that they are allocated a specific portion of their parent bank's global limits.

Counterparty limits are set by the Credit or Treasury areas of the institutions surveyed, as part of a general credit assessment of dealing counterparties. Most respondents conducted regular balance sheet appraisals in order to determine the financial strength of their counterparties; changes in credit ratings were monitored closely by most dealers. Other important factors that influenced the size of limits were requests from the dealing room, the level of existing turnover and future business opportunities with the counterparty concerned.

In some instances, separate product limits are in force (eg for foreign exchange transactions), while for others, the counterparty limit applies to the totality of the bilateral trading relationship. In the absence of a legally binding netting agreement, counterparty exposure limits have been designed to measure the gross value of all transactions that are awaiting settlement. For operational reasons, this exposure is often denominated and measured in USD terms.

There was a large degree of variance in the ways that respondents actually monitored compliance with exposure limits. Some respondents operate real-time credit monitoring systems, allowing dealers to check their current exposures before agreeing any further transactions with the same counterparty; others rely on ‘excess reports’ which are produced at the end of each day, comparing current bilateral exposures against established limits. Many respondents did both, updating counterparty limit utilisation on a real-time basis and also producing excess reports at day's end. As noted earlier, no respondent had systems in place to measure or monitor settlement risk according to the methodology adopted by the CPSS, but several indicated that their internal procedures would produce a similar result.

5.3.2 Netting arrangements

A clear majority of respondents indicated that they engage in some form of bilateral netting arrangement with their foreign exchange counterparties. For the most part, this was done on an informal basis, possibly reflecting the current lack of legal certainty for netting arrangements in Australia.^[1] No Australian-based dealer has yet joined a multilateral foreign exchange netting scheme, although some respondents indicated that they are contemplating avenues such as ECHO.

Beyond the fact that most dealers net some foreign exchange settlements, their responses displayed little else in common. Many respondents indicated that they are prepared to net only with their non-bank or corporate customers, while others would only consider netting where the counterparty was another bank or large financial institution. Several respondents were prepared to net in all currencies; others preferred the major traded currencies; while one respondent was only prepared to net transactions in Australian dollars.

Interestingly, while most payments netting occurred on an informal basis, many respondents noted that they had signed formal master netting agreements (eg ISDA, IFEMA) with some of their counterparties. While some of these agreements provide for payments netting as an option, all have close-out netting provisions in the event of a default by one party. Under such provisions, after a default, all outstanding transactions, for both spot and forward-dated settlement, are marked-to-market in a base currency and netted against one another, with the net present value of all outstanding transactions then payable by one of the counterparties.

5.3.3 Other risk management techniques

In addition to the specific information requested, some respondents also volunteered specific measures that they are taking to unilaterally reduce their exposure to foreign exchange settlement risk. Many institutions are making enhancements to their back office systems in order to more accurately measure and monitor their counterparty exposures. All deals generally now require a matched confirmation and standard settlement instructions.

Several of the dealers surveyed indicated that they have begun to renegotiate long-standing arrangements with their correspondent banks. Most are requiring nostro account statements to be delivered on a daily basis, or at least when there has been a movement on the account. Some have gone even further, requesting SWIFT MT910 messages (ie confirmations of credit) for individual receipts.

5.4 International initiatives

The RBA sought comments from survey respondents on the risk reduction measures that are currently being pursued internationally. These include the general move towards RTGS in most countries and the emergence of multi-currency settlement systems.

5.4.1 Impact of RTGS

Over the past two years, around ten currencies traded in the Australian market, including the GBP and HKD, have converted from deferred net settlement to RTGS. Almost all respondents reported that the introduction of RTGS in other countries had had little or no impact on their own settlement practices. This is not surprising, given Australia's time zone location and the fact that the top five traded currencies (which accounted for over 90 per cent of aggregate flows) are still currently settled on a deferred net basis.

As more currencies in the Asia-Pacific time zone adopt RTGS, there could be a noticeable impact on the duration of foreign exchange settlement exposure for these currencies. Cancellation times faced by Australian-based dealers in these currencies may be wound back. However, it is to be hoped that the introduction of RTGS offshore will also provide Australian dealers with a corresponding opportunity to reduce the time taken to reconcile receipts in these currencies.

5.4.2 Multi-currency settlement systems

Regardless of their differing positions on the merits of gross versus net settlement, most respondents believed that there is a useful role to be played by multi-currency settlement systems. However, many remained mindful about the cost of joining bodies such as ECHO, Multinet International Bank or the proposed CLS Bank.

At the time of the survey in April, many institutions were reluctant to commit resources to any of these competing projects until their viability was more certain.^[2] In October 1997, it was announced that ECHO, Multinet and CLS Services would merge to form a single industry utility, offering a suite of products to members, including bilateral netting, multilateral netting and continuous linked settlement. There was strong endorsement for such a merger from participants in the Australian market.

Ensuring that these emerging multi-currency settlement systems make adequate provision for the AUD will be one clear area where the RBA and local foreign exchange dealers will need to co-ordinate their efforts for communal benefit. While the AUD is already included in ECHO, it was not going to be amongst the first currencies settled by Multinet, and the G20 have yet to make provision for its inclusion in CLS. It is important that one of the world's most actively traded currencies not be excluded from these systems.

5.5 Areas for co-operation

In order to better understand where it can assist the industry reduce its exposure to settlement risk, the RBA encouraged respondents to identify areas where they saw scope for mutual co-operation. Some of the suggestions put forward by the industry are already being implemented, such as RTGS, while others will be considered by the RBA. The following section lists some of these suggestions as a basis for further discussion within the industry.

5.5.1 PVP solutions

Several respondents indicated that their preferred solution to foreign exchange settlement risk lay with linking national RTGS systems on a global basis, so as to achieve payment-versus-payment (PVP). This is already occurring in the European Union, as member states prepare for the introduction of TARGET.

However, the introduction of bilateral linkages between RTGS systems in Europe is being driven primarily by the demands of monetary union, not those of reducing foreign exchange settlement risk. Introduction of the euro will eliminate settlement risk for much of the current intra-European cross-rate trading, but transactions against the euro (eg EUR/USD) will be subject to foreign exchange settlement risk in much the same way as are transactions in USD/DEM, for example.

In terms of developing PVP solutions for the Australian market, the most important payments system offshore that needs to be considered is that of the United States. As revealed from the survey results, the USD is on one side of most foreign exchange transactions undertaken in Australia, including almost all of those involving the AUD. While Fedwire and CHIPS are now operating for 18 hours a day, the overlap with Australia remains small – no more than three hours, depending on daylight saving arrangements. Liquidity in both markets at that time is thin. To achieve a meaningful PVP overlap with the US will require that operating hours in Australia are lengthened. The RBA has canvassed this option previously with the banking industry. It has been agreed that the operating hours for the Australian RTGS system will not be extended until participants have had time to adapt to the new settlement arrangements.

5.5.2 Promoting regional dialogue

Several respondents saw benefits in the establishment of an Asia-Pacific forum to encourage, and possibly co-ordinate, action by foreign exchange dealers in the region. The EMEAP group of central banks, of which the RBA is a member, could be one such vehicle to promote regional dialogue on the issue of foreign exchange settlement risk.

The RBA is promoting the issue with other central banks and monetary authorities in the region. However, it should be recognised that, as there is very little direct trading of EMEAP currencies against one another, any solution or action plan developed within the region will require the involvement of organisations that are based in the United States.

5.5.3 Foreign exchange hedge market

An interesting suggestion to arise from the survey was a call for the reintroduction of the ‘hedge’ market in Australia. This market existed prior to deregulation and operated on a non-deliverable basis. Traders in the hedge market would agree on a transaction but, unlike current practice, neither party would physically deliver funds on settlement date. Rather, an amount equivalent to the difference between the contracted rate and a reference rate was payable on settlement date by one party in order to crystallise the profit or loss on the transaction.

In today's market place, a ‘hedge contract settlement’ would deliver benefits analogous to those of bilateral netting. The amount at risk of failure under a non-deliverable contract is only the marked-to-market profit on each transaction, rather than the full principal amount traded. In some Asian and Eastern European currencies, ‘non-delivery’ settlement is the industry standard. However, it would not be appropriate for the more actively traded currencies if the gross proceeds from the foreign exchange transaction were needed to fund an outgoing payment to a third party or another liability. In these instances, physical delivery would still be required. The use of non-deliverable ‘contracts for difference’ is also being discussed overseas as a potential means to reduce exposure to foreign exchange settlement risk.

Footnotes

The Government is expected to introduce legislation shortly to overcome these uncertainties. The RBA has long supported the introduction of legislation to validate netting arrangements in Australia. [1]

Two major participants in the Australian foreign exchange market have since signalled their intention to join ECHO once the legal position with respect to netting has been clarified by the Australian Parliament. [2]