Foreign Exchange Settlement Practices in Australia 4. Settlement Risk on Australian Dollar Transactions

4.1 Background

As noted earlier, previous studies of foreign exchange settlement risk have generally been limited to an examination of the G10 currencies. Nevertheless, the AUD is an actively traded currency in all of the major foreign exchange centres. The RBA is concerned to ensure that the level of settlement risk on AUD transactions is not out of line with those for other major traded currencies. It also wants to ensure that traders in AUD are not placed at a competitive disadvantage by solutions developed offshore which fail to make allowances for the Australian market.

All traders, whether based in Australia or offshore, face exposure to foreign exchange settlement risk on their AUD transactions. However, even though the AUD is traded in many countries, it is not widely quoted – and therefore settled – against any currency other than the USD. While Australia provides the largest market for direct cross-rate deals in AUD, even this market is relatively small, accounting for less than four per cent of domestic AUD turnover.

4.2 Domestic settlement arrangements

Settlement of AUD transactions for a dealer's own account is effected through many different means, both direct and indirect. This is illustrated below in Table 2, which represents an average day's settlement activity for the 24 survey respondents.

Most of the banks surveyed pay and receive AUD as a principal in at least one local clearing system and have direct responsibility for the final settlement of these transactions on the following business day. While non-bank dealers may also be responsible for making and receiving their own AUD payments (eg if they have access to an Austraclear or SWIFT terminal), settlement of such payments is performed by their banker.

However, the survey revealed that not all banks settle directly for AUD foreign exchange payments. The use of extensive correspondent banking and agency arrangements by many banks for the domestic currency leg of foreign exchange transactions was evident from the survey responses. The most common arrangement was for paper clearing, where many foreign exchange dealers maintain their own accounting records (and may even collect and disburse warrants themselves), but use a large clearing bank for the settlement of these instruments. Use of a nostro account at a larger bank to make and receive payments was also a common method for settling foreign exchange transactions in AUD.

4.3 Issues for domestic dealers

4.3.1 Measurement problems

The use of different systems and payment instruments makes identification and measurement of foreign exchange settlement risk on AUD transactions more difficult than for many other currencies. For example, some means of settlement in Australia provide for ‘assured payments’ (ie those with agreed irrevocability); some alternatives are clearly conditional (eg cheques); and other methods, such as correspondent banking, vary from case to case.

This fragmentation is thought to be the reason for the high number of survey respondents under-estimating the duration of their exposure to foreign exchange settlement risk for AUD transactions. Many respondents regarded the time of ‘finality’ for AUD transactions as the local close of business, rather than at 9.00 am the next day. In addition, several respondents indicated that they reconcile their AUD settlement flows on value date, rather than waiting for interbank settlement to be completed (which, as discussed earlier, is the event that confirms finality).

Ordinarily, early reconciliation of receipts would constitute sound practice. Indeed, it allows Australian dealers to reduce their risk profiles by providing some scope to cancel the USD leg of a transaction if it is discovered the AUD side has definitely not been delivered (ie Status F transactions). However, if it is confirmed that the counterparty has delivered the AUD, this amount must still be considered at risk of failure (as opposed to actually having failed) until interbank settlement has been completed at 9.00 am the following business day. In the CPSS methodology, the transaction has entered the Status U phase. Depending on whether weekends intervene, this period can range anywhere from one to three calendar days after the actual value date, or even longer with public holidays. By reconciling expected receipts (rather than final receipts) on value date, domestic dealers are under-estimating their true exposure by some 16 hours, on a standard day, implicitly discounting the possibility of a failure to settle the following morning.

4.3.2 Trading patterns

As noted earlier, the overwhelming majority of foreign exchange transactions in AUD involve the USD on the other side. However, some direct cross-rate trading does occur, albeit in low volumes, against other currencies. Table 3 shows the weighted average time, in hours, that foreign exchange transactions are at risk for the five most actively traded AUD pairs.

Table 3

Settlement risk on AUD transactions (hours)

Currency pair	AUD bought	AUD sold
AUD/USD	12	33
AUD/JPY	23	25
AUD/DEM	17	30
AUD/NZD	24	26
AUD/GBP	16	32

Several points of interest arise from the information presented in Table 3. First, the exposure to foreign exchange settlement risk on AUD transactions is the most variable for deals that involve the USD on the other side. The difference in exposure between paying and receiving AUD for USD is around 21 hours. Reducing the period of risk where the AUD is sold against the USD is critical because AUD/USD deals are the most prevalent of all AUD transactions, both domestically and offshore.

Second, it is clear from Table 3 that foreign exchange settlement risk on AUD transactions is much more than a time zone problem. The superficial ‘pay early, receive later’ analysis of the original Bankhaus Herstatt incident in 1974 does not withstand close scrutiny. Deals involving the AUD against the JPY and NZD are at risk, on both sides of the transaction, for around 24 hours, despite the small time zone differences that exist between Sydney, Tokyo and Wellington.

Third, Australia's next-day settlement arrangements do not assist in the reduction of foreign exchange settlement risk; in fact, they prolong the period of exposure. As noted earlier, receipts in AUD are not final until 9.00 am on the business day after value date and should not be reconciled with finality until this time. If same-day settlement were in place, as it is generally elsewhere in the world, the period of risk where the AUD was purchased could be reduced by ten or more hours, and possibly eliminated. Such a reduction would be possible despite the fact that the length of exposure on such transactions is already less than that when the AUD is sold and foreign currency is purchased.

4.4 Issues for offshore traders

4.4.1 Settlement arrangements

Offshore traders in AUD face broadly similar risks to those of domestic dealers that trade in ‘third’ currencies (ie those without an AUD component). They need to establish arrangements to make and receive payments in the currency, and must negotiate appropriate cancellation and notification times with local correspondent banks. In addition, they need to be aware of the time when AUD receipts can be considered ‘final’, taking into consideration the different payment systems/instruments used and the deferred settlement arrangements that currently exist in Australia.

Thirteen of the 24 survey respondents indicated that they offered correspondent banking services to offshore traders of AUD. For some, this vostro account business is confined to servicing the AUD payment needs of their head office or branches, while for others, it represents an extensive and profitable line of business in its own right. Importantly, it needs to be recognised that this activity does not generate foreign exchange settlement risk for the Australian banks that offer the correspondent banking services. The domestic bank is merely acting on advice from its offshore correspondent and generally has no commercial interest in the settlement of the foreign currency leg of the underlying transaction (which will usually be USD).

This situation of Australian banks making or receiving ‘one-sided’ payments to settle foreign exchange deals done by offshore customers is to be contrasted with that where deals are settled for the bank's own account: in the latter case, the local bank has an interest in the settlement of both currency legs, regardless of whether one currency happens to be the AUD.

4.4.2 Settlement flows

Of the 13 respondents who indicated that they did provide correspondent banking services, most could not isolate that portion of vostro account turnover which was related to foreign exchange activity on the part of offshore traders. Table 4 details the composition of total vostro account activity reported by those survey respondents that provide such services to offshore traders of AUD.

The level of daily settlements generated from vostro account activity is comparable to that reported by all 24 survey respondents when settling AUD transactions for their own account. While the figures presented in Table 4 are contaminated by non-foreign exchange payments (and therefore over-estimate the case), large AUD settlements originating from offshore are to be expected because the AUD is traded in all of the major foreign exchange centres. Overseas banks are important counterparties in the AUD market.

4.4.3 Cancellation deadlines

As most respondents were directly responsible for the settlement of transactions in the domestic currency, the cancellation times reported for ‘own business’ in AUD were the most favourable of all the currencies traded. This was to be expected. Essentially, the time of cancellation faced by domestic dealers is dependent upon the rules of the system which they use to send the payments.

However, this is not the case for offshore traders in AUD. Like domestic dealers trading in third currencies, offshore traders must issue payment instructions to their Australian correspondent, who will set a deadline after which they cannot guarantee that the payment can be cancelled. The range of cancellation times reported by survey respondents for their offshore correspondents is presented in Table 5.

As can be seen above, most cancellation deadlines for offshore traders are before the Australian payments system opens or very early on value date. Of those survey respondents who set later cut-off times, most acknowledged that a request during the business day by an offshore correspondent to cancel an AUD payment could only be handled on a ‘best endeavours’ basis.

4.4.4 Notification of receipts

As with domestic dealers trading in foreign currencies, offshore traders in AUD must rely on advice from their Australian correspondents to verify the receipt of the AUD leg of their foreign exchange deals. The range of notification times reported by survey respondents for their offshore correspondents is presented below in Table 6.

As with the reconciliation of their own transactions in AUD, many respondents which offered correspondent banking facilities regarded the time of finality for vostro account receipts as the close of business on value date, rather than at 9.00 am on the following business day. For most Australian banks, the time when vostro account statements are sent to customers offshore is determined by operational considerations.

While several respondents issued vostro account statements to their offshore correspondents before it was certain that interbank settlement in AUD would be completed, few had formal arrangements in place with their correspondents regarding the impact of a failure to settle on the following morning. Some respondents indicated that they issued statements on the proviso that all receipts were conditional upon final settlement occurring; others were not sure whether they would (or could) reverse the credits to vostro accounts if the paying bank failed to settle subsequently. In many instances, the responses differed according to which payments system or instrument was used to make the transaction.

4.5 Real-time gross settlement in Australia

The introduction of RTGS will vastly improve certainty in the measurement of foreign exchange settlement risk on transactions involving the AUD. It will allow both domestic and offshore traders in AUD to confirm, on value date, that they have – or have not – received final AUD funds. While many dealers already reconcile their AUD receipts on value date, the current next-day settlement arrangements in Australia mean that such practices under-estimate the true risk profile by many hours.

Under RTGS, this will no longer be the case. Once a payment instruction has been forwarded onto the receiving bank, there can be no question about its status – it has been settled at the RBA and the proceeds are final, with cleared funds in the hands of the receiving bank (and its customers). For the sending bank, the latest cancellation time will be represented by the time of settlement at the RBA – if there are sufficient funds on account with the RBA when the payment instruction is sent, settlement is immediate and the payment cannot be revoked; if not, the payment may still be cancelled while it is queued, awaiting settlement.

The real-time settlement of all interbank foreign exchange transactions in AUD will put Australia at world best practice. Of the nine most actively traded currencies, the AUD will join only the GBP and CHF in being settled exclusively by RTGS. The world's three major traded currencies – the USD, DEM and JPY – are not settled principally by the RTGS system in each of their respective countries and there are no indications that this situation will change in the immediate future.