Concerns raised over Basel settlement risk guidance as consultation closes

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A new set of supervisory guidance on the management of foreign exchange settlement risk should make risk management practices more consistent across the FX industry, but it could reap unintended consequences if implemented inconsistently by regulators, senior bankers have warned.

The new guidance, which was published by the Basel Committee on Banking Supervision in August, has been open for public consultation for the past eight weeks and market participants have until tomorrow to submit their comments to the committee.

"The risk is that the guidelines could be enforced in such a way that creates distortions in the market that could give advantages to this or that institution depending on where they are based," says the head of FX at one European bank. "Or even worse, they could be so draconian that banks in general will have to add the additional costs into their pricing and the market will become less liquid, which will result in costs for the real economy."

The guidance is intended to expand upon and replace a set of supervisory guidance first published by the Basel Committee in September 2000, two years before the launch of CLS, which mitigates settlement risk through a payment-versus-payment (PVP) mechanism. The new guidance acknowledges the progress made by the industry over the past 12 years, but it pushes for greater use of PVP settlement systems such as CLS.

"Since 2000, the FX market has made significant strides in reducing the risks associated with the settlement of FX transactions," the report states. "However, substantial FX settlement-related risks remain due to rapid growth in the FX trading market. In addition, many banks underestimate their principal risk and other associated risks by not taking into full account the duration of exposure between trade execution and final settlement."

The revised guidance puts the onus on banks and supervisors to increase their efforts to reduce settlement risk, in particular by increasing the scope of currencies, products and counterparties eligible for PVP settlement. Divided into seven key guidelines, the report tackles governance, principal risk, replacement cost risk, liquidity risk, operational risk, legal risk and capital requirements.

"It is pushing towards doing things in a more standardised way. A lot of people manage settlement risk within their organisations, but they do it in a way that has grown up in an ad hoc manner, which makes things hard for regulators – in terms of comparability, for example. There is a sense of trying to take control and create more alignment in a way that makes sense for the regulators," says a regulatory adviser at one bank in London.

CLS declined to comment for this article, but the firm is understood to be finalising its response to the Basel Committee ahead of tomorrow's deadline. "It's a fair and neutral paper that promotes the use of PVP settlement but takes into account the share of non-PVP settlement associated with FX transactions," says one source close to CLS.

Banks say the guidelines are broadly in line with the work they have been doing collectively for many years, and should not require significant changes to the way in which they operate. But some elements of the paper have raised concerns, including the third guideline, which mandates banks should employ prudent risk mitigation regimes to properly manage replacement cost risk for FX transactions until settlement is final. Netting and collateral are highlighted as key mechanisms in tackling replacement cost risk, which some believe could detract from the industry's focus on settlement risk.

"We've gone a long way in mitigating settlement risk, and indeed replacement risk, and we already have credit support annexes that allow for the use of initial margin and variation margin. The client base we have in the FX market – for example corporates, who have fairly specific needs and wants – might not be best placed to accept mandatory initial and variation margin charges. They might not have the capital in place to do that kind of thing," argues Jeremy Hill, head of foreign exchange and money market operations at Royal Bank of Scotland in London.

The seventh guideline tackles capital requirements for FX transactions, stressing that banks must consider all FX settlement-related risks when calculating the amount of capital to be held against exposures. While some participants see the guideline as a backstop measure to ensure regulators can impose additional capital requirements on banks whose settlement risk management is a concern, others are against additional capital requirements.

"We do view the potential imposition of a capital charge as something that needs to be looked at very carefully, as there is the risk that any capital charge would be relatively meaningless against the actual value of potential settlement failure in the FX market. Really, focus should be put on prevention rather than some kind of insurance," says Hill.

While the paper covers a range of issues relating to settlement risk, an underlying theme is the push to expand the use and scope of CLS as the industry's main PVP settlement utility, says the head of FX at one US bank. He believes the threat of extra capital and collateral charges could ultimately lead to a price distinction in the FX market, where non-CLS-settled trades cost more for the investor.

"In general, the US authorities don't think that the way to manage foreign exchange is to have initial margin held in a third-party account – they think the way to do it is to eliminate settlement risk. If you don't have settlement risk, your capital charges should be a lot lower; if you do have it, they should be a lot higher. Right now, I don't think there is any differentiation in pricing between banks that are on CLS and those that aren't, and I think this is the first step towards that," he says.

CLS currently covers 17 currencies and is actively seeking to add further currencies, but that process relies heavily on the support of central banks. The last currencies to be added were the Mexican peso and the Israeli shekel, in May 2008. "It is important to highlight the encouragement of the central banks, which in some cases is still missing – central banks need to encourage the use of PVP settlement," says the source close to CLS.

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