Foreign Exchange Settlement Practices in Australia Executive Summary

Trading in foreign exchange markets involves the management of many risks, including liquidity risk, exchange rate (market) risk and operational risk. One of the largest risks facing foreign exchange dealers is settlement risk. This is a credit risk, whereby a party to a foreign exchange deal may deliver funds in the currency that was sold, but not receive the corresponding funds in the currency that was purchased.

Settlement risk arises because the two legs of a foreign exchange transaction are delivered in different countries, often in different time zones. However, while time zone differences are an important determinant, studies by the Bank for International Settlements and others have revealed that foreign exchange settlement risk is more than just an intra-day phenomenon. The exposure lasts from the time that a payment instruction for the currency sold can no longer be cancelled unilaterally until the time that the currency purchased is confirmed as having been received with finality.

This report presents the results of an investigation by the Reserve Bank of Australia (RBA) into the settlement practices of the Australian foreign exchange market. It reveals that dealers in Australia are exposing themselves to large potential risks as a result of the settlement process for foreign exchange transactions. Based on the survey results presented in this report, the settlement exposure of the Australian industry, at any point in time, represents a multiple of its capital base.

While the values at risk are a natural consequence of trading in the world's ninth largest foreign exchange market, it is the length of time that Australian dealers are exposed to risk that is of particular concern. Exposures lasting in excess of 24 hours are the norm; for many currency pairs, the period of exposure lasts for over three business days and can extend out to a month for some of the more thinly traded currencies. The reconciliation practices adopted by many of the dealers surveyed fall far short of meeting international best practice.

Recognising the importance of the Australian dollar on global foreign exchange markets, the report specifically examines the settlement risk profile for transactions that involve an Australian dollar leg. In addition, it also examines the techniques applied by Australian dealers to limit or manage their exposures. Most dealers set limits on their accumulated counterparty exposures, although none measures its exposure in accordance with the methodology proposed by the Bank for International Settlements and adopted in this report.

The results of this survey are of some concern, as were the results of the overseas studies. Overall, though, Australian practice does not appear to vary significantly from that reported for the G10 banks in 1995. While several of the institutions surveyed in Australia are acutely aware of their exposure to foreign exchange settlement risk and are seeking ways of reducing and better managing it, many more are still struggling with the issue. There is a general sense that Australian institutions are not addressing foreign exchange settlement risk with the same urgency as some of their G10 counterparts. The RBA will be looking for a demonstrable improvement when it undertakes a further study of the Australian foreign exchange market in 1998.