Settlement risk has been greatly reduced, but not yet eliminated.
Readers may have noticed press reports about a consultative report issued last month by the Committee on Payment and Settlement Systems of the Bank for International Settlements entitled "Progress in Reducing Foreign Exchange Settlement Risk". The report is a useful update of the progress made over the past 10 years in reducing the systemic risk arising from the settlement of foreign exchange trades. It concludes that the strategy adopted by the G10 central banks, which pioneered the initiative of reducing settlement risk in 1996, has achieved significant success, citing the establishment and growth of CLS Bank1 as one of the major achievements. But the report also identifies remaining large and long-lasting exposures arising from settlement of foreign exchange trades and recommends a range of actions to be taken by individual institutions, industry groups and central banks to reduce and control them.
The report contains the results of a survey conducted by the Committee in the second half of 2006, involving 27 central banks and 109 financial institutions, covering 80% of the foreign exchange markets in 15 currency areas. According to the survey, the average daily foreign exchange settlement obligations in April 2006 amounted to US$3.8 trillion, of which 32% were settled through the traditional correspondent banking channel and therefore subject to settlement risk. This represents a substantial improvement from 1997, when a similar survey indicated that about 85% of the obligations were settled by this method. The report concludes that the improvement is attributable to the work of CLS Bank and an increasing use of payment-versus-payment services now available in many jurisdictions, including Hong Kong.
I am sure readers of this column are familiar with my continuing encouragement to all concerned in large-volume trading in financial markets to manage their settlement risks. We move money around the world and complete transactions by merely touching a few buttons on a keyboard, thanks to advances in information technology. But perhaps because of the ease of transferring large sums of money these days, people may not be fully aware of the risk of not being able to get what they are supposed to in return for their money, which is likely to happen if the payments of the two parties are not done simultaneously, or if there is no guarantee of compensation by a third-party clearing house in case of default by either party. The classic example of this kind of settlement risk is called Herstatt risk, a term originating from the failure of Bank Herstatt in what was then West Germany in 1974 as a result of its failing to meet its foreign exchange commitments. On the day when the bank was closed down by the West German authorities, the bank’s counterparties in New York, who had already been debited in Europe but had not yet received the corresponding dollar amount due to them because of the time difference suffered substantial losses. But settlement risks can occur even in transactions carried out on a single day in the same time zone if the financial infrastructure is not designed to eliminate, or at least minimise, them.
The HKMA has made a lot of effort over the years to help banks in Hong Kong to reduce their settlement risk as far as possible by improving the interbank payment infrastructure. Our aim is to build the most advanced and reliable multi-currency, multi-dimensional platform to provide real-time, payment-versus-payment and delivery-versus-payment services to users. The first real-time gross settlement (RTGS) system in Hong Kong for transactions denominated in Hong Kong dollars was introduced in 1996. Since then large-value interbank payments are no longer settled by end-of-day netting, but on a continuous, deal-by-deal basis through the banks' settlement accounts with the HKMA. As these payments are settled one by one during the day, with payments for each transaction done simultaneously and in gross amount, systemic settlement risks arising from end-of-day netting are eliminated. In 2006 the Hong Kong dollar RTGS system handled transactions involving $579 billion each day. On 27 October 2006 the system registered a record turnover of $1.37 trillion because of large initial public offerings.
Building on the success of the Hong Kong dollar RTGS system, we introduced the US dollar RTGS system in 2000 and the euro RTGS system in 2003. In June this year we completed a system upgrade to introduce the renminbi RTGS system. These four RTGS systems are linked, so that users can now enjoy multi-currency as well as single-currency real-time payment-versus-payment services in Hong Kong.
But the hard work of financial infrastructure development does not end there. We aim to develop Hong Kong into a regional payment and settlement hub so that not only financial institutions in Hong Kong but also those in the region or even on other continents can enjoy world-class settlement services without worrying about settlement risk. System development for using our US dollar and euro payment systems to process cross-border payments in the region through Hong Kong is now underway. We linked our US dollar RTGS system with Malaysia's ringgit RTGS system in November 2006, and are pursuing opportunities for similar links with other economies in the region. Put simply, our aim is to make Hong Kong a place for financial institutions, and indeed anyone, active in the foreign currency markets to do business without having to worry about settlement risk.
As the BIS report points out, there is still a lot of hard work ahead in order to achieve the ultimate goal of making settlement risk a historical term and to avoid the risk of backsliding. We will work with the industry associations, and individual banks if necessary, to further reduce the remaining settlement risks to maintain and build on Hong Kong's status as an international financial centre.
Joseph Yam
9 August 2007
1CLS Group, which includes CLS Bank and CLS Services, was founded in 1997 to provide the first global settlement system for 15 currencies and is supported by more than 70 international banking and financial institutions. The CLS Bank acts as a clearing house for foreign exchange transactions.
Click here for previous articles in this column.
Document in Word format
