Foreign Exchange Trading and Settlement: Past and Present
McPartland, John W., Chicago Fed Letter
Since 1989, global foreign exchange turnover (and settlements) has more than tripled, to just over $2 trillion per day. This article expands upon a January 2005 Chicago Fed Letter that described broad clearing and settlement principles, and focuses more specifically on foreign exchange settlement practices, past and present.
In the 1970s, foreign exchange (FX) trading emerged as a significant line of business for large, internationally active financial institutions. Prior to the mid-1970s, the true commercial need to convert demand deposit account balances from one currency to another was related to import/export transactions that involved letters of credit, and FX rates for any currency tended to be fixed, pegged to another currency, or otherwise contained within predefined target ranges. During the 1970s, FX rates began to float freely; once currencies were free to seek their own economic values, banks quickly realized that FX trading rooms were potential profit centers. More importantly, the methods by which trading counterparties today deliver the currency sold, and receive the contra-currency purchased, are far better and safer than the methods under which FX trades settled in the 1970s and 1980s.
In the 1970s, there were many more European currencies than there are today. Traveling from one European country to another or conducting business in a variety of European countries required that one had sufficient quantities of the proper currencies of all these countries. Imagine traveling from Texas to California, passing through New Mexico and Arizona, with each requiring its own "state" currency. Today, the so-called eurozone (comprising 25 member states of the European Union) has a single currency, the euro, which is the second most dominant (traded) currency in the world behind the U.S. dollar.
An FX trade, by definition, involves two currencies, the currency sold and the currency purchased, for example, selling U.S. dollars (USD)1 and buying British pounds sterling (GBP). Foreign exchange transactions always involve both a trade date and a settlement date. The latter is typically called a value date-the forward banking day common to both countries2 on which both parties to the transaction will pay the currency amount they are obligated to pay with the full expectation that they will receive the currency amount that they are entitled to receive.
Foreign exchange trades typically settle according to standardized settlement conventions, e.g., "for spot" or in two business days; for 30, 60, or 90 calendar days forward; and on the Wednesday following the third Monday of March, June, September, and December.3 Although most FX is traded for spot, many FX transactions are negotiated either well before the planned settlement date (usually to lock in the rate of exchange in advance) or just before the date of a well-anticipated commercial transaction (if fixing the rate of exchange in advance is not a priority).
Finally, there is the issue of temporal risk. Depending on the countries involved, the actual payment of the currency sold and receipt of the contra-currency received will almost certainly occur at different times (but on the same day) and could occur as much as 14 hours apart.
"Trust me" FX settlement
In the early 1970s, the trading of FX was dominated by very large international banks. Settlement payments were made on trust that the contra-currency would be remitted by the counterparty on the proper value date. Banks were accustomed to quantifying and limiting risk exposures to each other, and the trading and ultimate settlement of FX transactions involved such exposures. As there were then no techniques that might have ameliorated the temporal and principal risks associated with FX settlements, those risks were recognized for what they were and addressed by the trading and settlement limits that banks set for each other.4
This "trust me" system of settling FX transactions worked fairly well until June 26, 1974. …