Tackling settlement risk is a serious business

Unless market participants come together, the risk in the system is here to stay

For many years, settlement risk in foreign exchange has been relegated to the background. Not because the risk in itself wasn’t there, but because banks and regulators alike were confident everything was under control in the safe and capable hands of CLS – the industry utility put in charge of tackling the issue almost 20 years ago.

Sure, there had been some infamous cases – Bank Herstatt in 1974 being the most notable – that every now and then would renew focus on the topic. The widespread panic during the financial crisis of 2008 brings back raw feelings, with one head of FX prime brokerage at a global bank recalling how, during the Lehman Brothers collapse, “I was there sending out US dollars and praying that the yen would arrive – it was no fun”.

Aside from a few isolated cases, however, the subject of settlement risk would rarely surface in conversations on the state of the FX industry.

But when the Bank for International Settlements crunched the numbers this time last year, things looked gloomier than expected. Not only was settlement risk on the rise, but the changes needed to tackle the structural issues that have been driving it up would require some radical action by the market.

The good news is market participants took the warning seriously and responded positively to the call for action. The topic started being debated within various central bank FX working groups, and CLS itself took centre stage by bringing new ideas to the table.

So far, no one has figured out the best way to aggregate in a comprehensive way the data available on the number and size of trades that aren’t being settled

Whether the proposed solutions will be enough remains to be seen, but it’s a move in the right direction.

The not-so-good news is the lack of clarity on the origins of this renewed wave of risk in the system. So far, no one has figured out the best way to aggregate in a comprehensive way the data available on the number and size of trades that aren’t being settled.

One of the reasons is the lack of co-ordination between parties.

The BIS publishes its figures after conducting surveys at central banks, which in return aggregate data coming from their domestic banks. But the absence of a regulatory mandate for banks to report settlement data is potentially leaving big gaps in the numbers being reported.

For obvious reasons, CLS can only present figures coming from the flow settled by its 73 members and the roughly 28,000 third-party participants who use its services. Whatever happens outside of that circle remains unaccounted for.

If market participants are serious about tackling settlement risk – and the early signs point in that direction – the first item on the agenda should be to find ways to present the full picture. Only then it will be possible to measure the extent of the actions required.

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