Foreign Exchange Settlement Risk Survey. (Articles)

By Rodgers, Andrew | The Reserve Bank of New Zealand Bulletin, December 2001 | Go to article overview

Foreign Exchange Settlement Risk Survey. (Articles)


Rodgers, Andrew, The Reserve Bank of New Zealand Bulletin


The world's central banks have been working for several years to promote awareness of the risks associated with the settlement of foreign exchange transactions. In September 2000, the Reserve Bank surveyed the major participants in the New Zealand foreign exchange market to focus attention on settlement practices and the potential risks. This article summarises the findings of that survey.

1 Introduction

International trade and investment require the buying and selling of different currencies in the foreign exchange markets. The amounts involved are very large. The April 2001 Bank for International Settlements survey of foreign exchange and derivatives market activity estimated daily global foreign exchange turnover of USD1,210 billion. Turnover in the New Zealand market was estimated to be on average about USD4 billion each day. (1)

Foreign exchange settlement risk is the risk that a participant in the foreign exchange market will lose the full principal amount of a foreign exchange transaction. Such a loss would typically occur when the sold currency has been irrevocably paid away, but due to the failure of the counterparty, the bought currency is not received. Foreign exchange settlement risk is of particular concern to central banks given the large values involved in settling foreign exchange transactions and the resulting potential for the failure of one institution to impact on the rest of the financial system.

The potential systemic consequences were demonstrated by events in 1974, when a small German bank, Bankhaus Herstatt, failed. At the point that the bank failed, several of its counterparties had irrevocably paid Deutschemarks to Herstatt against anticipated receipt of US dollars later the same day in New York. On the announcement of Herstatt's closure (at 10.30 am New York time), Herstatt's New York correspondent bank suspended payments from its account and the counterparties were left exposed for the value of the Deutschemarks that they had delivered. Hence, foreign exchange settlement risk is commonly referred to as Herstatt risk.

In June 1995, the Committee on Payment and Settlement Systems (CPSS) of G10 central banks conducted a survey of the foreign exchange settlement practices of about 80 major banks, with a view to assessing the extent of the risk facing banks. (2) The results of the survey were published in order to draw to the banks' attention the fact that they were facing some very large exposures. (3) In 1996, the CPSS adopted a strategy aimed at reducing foreign exchange settlement risk. As part of this strategy, the CPSS encouraged central banks to promote action by commercial banks to manage and reduce their foreign exchange settlement risks.

The CPSS subsequently conducted a follow-up survey to monitor progress in implementing improvements in practices. The results of that survey were published in July 1998. (4) The CPSS also released in January 2000 a "toolkit" to assist other central banks to understand and tackle foreign exchange settlement risk.

In order to address concerns about foreign exchange settlement risk in the Asia-Pacific region, the Executives' Meeting of East Asia-Pacific Central Banks and Monetary Authorities (EMEAP) agreed in 1999 that member countries should each conduct their own survey on foreign exchange settlement risk, modelled on the G 10 survey. It was intended that the EMEAP survey would promote awareness of the risk in the region and encourage improvements in foreign exchange settlement practices. The EMEAP Working Group on Payment and Settlement Systems was delegated the responsibility of co-ordinating the conduct of the surveys and publishing the results. The survey form to be used was based on that developed by the CPSS and included in their toolkit. Two EMEAP members-the Reserve Bank of Australia (RBA) and the Bank of Japan - had previously conducted their own surveys. (5)

As part of the EMEAP initiative, the Reserve Bank conducted a survey of participants in the New Zealand foreign exchange market in September last year. …

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