Settlement Risk in FX: What a Bank Is Exposed To

A forward exchange contract fixes a rate today for an exchange of currencies on a later date, the value date. For most of its life the bank's risk is replacement cost: if the client failed, the bank would have to strike the same deal again at the market rate, and it would lose only the difference. That risk is usually a fraction of the contract's face value and is covered by a derivative credit limit.

On value date the principal moves. The bank pays out one currency and expects to receive the other. If its payment goes first and the client's does not come, the loss is no longer a rate difference. It is the full sum the bank paid away, with a claim against the client for the same amount. The risk carries the name of Bankhaus Herstatt, a German bank closed by its regulator during the business day in June 1974, after counterparties had paid it German marks and before it paid out the US dollars they were due.

The Basel Committee's 2013 guidance on foreign exchange settlement asks banks to reduce this principal risk as far as practicable by settling through arrangements that offer payment-versus-payment, and to manage what remains in the same way as other exposures to the same counterparty of similar size and duration.

Between banks, CLS settles both legs of a trade at the same moment or not at all, across 18 currencies that include the US, New Zealand and Australian dollars and sterling. Its members are large banks; other institutions reach it through them. A mid-market client's forwards with its own bank usually settle outside it, so the bank controls the risk itself, in one or more of four ways.

It can debit the client's account first, which works where the client banks with it and has the funds or the overdraft room. It can pay only on receipt, releasing its side once the client's money has arrived, which removes the risk but may delay the client's supplier. It can net same-day contracts in the same currency pair, so only the difference changes hands, where the documents allow. Or it can set a daily settlement limit: the most it will pay out to that client on any one day before the client's side has arrived, approved by credit like any other short loan and separate from the line that covers the contracts before value date.

An importer of medical equipment, constructed for this page, buys US dollars forward to pay its overseas suppliers and pays the bank in its home currency. Three forwards fall due on 14 March, worth US$2.4m in all. The client banks elsewhere for its operating account, so its payment arrives by transfer. Its bank has approved a daily settlement limit of US$1.5m. The figures belong to the example.

The client's payment arrives at two o'clock and the bank releases the last US$900,000. The suppliers are paid a few hours late, and the importer's treasurer learns that bunching three contracts on one date has a cost. Had a receiver been appointed at noon, the bank would have held a claim for US$1.5m, not for the US$72,000 the contracts were worth the day before. Whether that claim is secured depends on whether the bank's security secures all money owed to it, as an all-monies general security agreement in New Zealand or Australia, or debenture in the UK, would.

The two are the same counterparty risk at different moments. Pre-settlement risk runs for the life of the contract and is the cost of replacing it; the bank sizes it with potential future exposure and approves a line for it. Settlement risk lasts hours, perhaps a day, and is the principal itself. One file carries both limits, and a client can be well inside its pre-settlement line and over its settlement limit at once, because the first is used by the term and size of all its contracts and the second by how many fall due on the same day.

Settlement risk is also distinct from a payment that is late for operational reasons. A failed instruction that is fixed by the afternoon is an operational event; the credit question is whether the client can pay at all.

DEFINED IN ONE PARAGRAPH → · THE PRE-SETTLEMENT LINE → · PRODUCT FILE: FX FACILITY →

When an FX facility is approved, the settlement limit is sized to the largest day the client expects to settle, and that depends on how it spreads its contracts. A business that hedges a season with one value date needs a large limit for one day a year; the same cover spread across weekly dates, or bought as window forwards the client can draw down in parts, needs a fraction of it. The credit officer often asks for the second before approving the first.

The limit is also a lever that moves quietly. When a client weakens, a bank can withdraw the settlement limit and move to paying only on receipt. Nothing in the facility changes, but the client must now fund each settlement in advance, which pulls cash forward at the moment it is scarce. A borrower's treasurer reads that change as the bank reading its credit.

A FORWARD CONTRACT FOR AN EXPORTER → · HOW BANKS READ EXPORTERS → · WINDOW FORWARD →