ECB Adds to FX Settlement Risk Warnings

The European Central Bank has joined a long list of central banks and regulators to warn over the potential cost of FX settlement risk, a subject that was first given profile by the Bank for International Settlements in the 2019 FX Triennial Survey.

In its latest newsletter, the ECB observes that FX markets have not been immune to higher volatility, partly due to monetary policy normalising at a different pace in different parts of the world. “This has reminded us that situations in the market can rapidly change,” the central bank says, adding, “Sound governance and proper risk management are therefore of the essence – including sound management of FX settlement risk.”

While FX settlement risk is a tail risk, it remains “very significant and continues to grow”, the newsletter states. Hence, the ECB has assessed the FX settlement risk management practices of a sample of banks, with a particular focus was on the governance arrangements as well as on the measurement, management and mitigation of FX settlement and related risks. The assessment was performed on the basis of the 2013 Supervisory guidance for managing risks associated with the settlement of foreign exchange transactions published by the Basel Committee, also considering the FX Global Code update from July 2021.

“This review has enabled the ECB to identify a number of sound risk management practices that have already been shared with banks,” it states. “The ECB will follow up on banks’ adherence to these practices.”

The main dimensions of sound FX settlement risk management are cited by the central bank as the effective measurement, limit setting and usage, the management of failed trades and theinvolvement of management at board level as well as internal incentives to reduce the risk.

The ECB says banks’ policies and procedures must establish how FX settlement risk is measured, clearly stating the method chosen for calculating duration (in particular for principal risk). When banks account for the full period of duration, this should begin with the unilateral cancellation deadline and end with the reconciliation and investigation of failed trades. Banks using approximation methods should be able to demonstrate that they do not underestimate the risk including under stressed conditions.

On limit setting and usage, the ECB says banks should ensure that FX settlement exposures are subject to “prudent and binding limits”. Limits should apply to the FX settlement amount for the full duration of days between the unilateral cancellation deadline and when the incoming payment is reconciled. FX settlement exposure should be closely monitored and updated when new deals are closed or when events (such as failed trades) cause the exposure to last longer than expected.

Another important element is the adequate and prudent management of failed trades. Effective monitoring of failed transactions is crucial, as unexpected failures cause exposures to be higher than expected. In this regard, banks should be able to promptly identify failed trades and take appropriate action, the ECB points out. Instead of removing a trade from their systems immediately after the settlement date, banks should first account for whether they indeed received the currency they bought, or whether the trade effectively failed.

“A failed trade represents continued exposure for the full principal value of the operation until they investigate the reasons for failure and have taken the necessary actions,” the ECB states. “Banks should thus include failed trades in their measures for current and expected exposure and continue considering them as existing exposures against the applicable limits for as long as the incident is not resolved.”

The board of directors should be ultimately responsible for ensuring that the institution has strong governance arrangements that require all FX settlement-related risks to be properly identified, measured, monitored, and controlled throughout the business. Banks should also have internal processes in place to ensure the regular and timely reporting of FX settlement risks to the relevant risk management function or senior management member, as appropriate. If the risk is considered material or its materiality increases, the board should receive sufficient and timely information on the risk level and management of the FX settlement risk, and should in any case be promptly informed of any serious incidents.

Finally, the ECB echoes several other recommendations from, amongst others, the BIS, Basel Committee, CPMI and Global FX Committee, by stating that banks should use payment versus payment (PvP) settlement to eliminate principal risk when settling FX transactions, where practicable.

To fully address FX settlement risks, the ECB says banks’ incentive schemes, business practices and infrastructures must be properly aligned. Banks should define effective incentives to reduce the risks associated with FX settlement, by for instance differentiating and passing on the costs to business units based on the risk profiles of their transactions, or by allocating penalties and financial costs from settlement incidents to the initiating business units.

Interestingly, the ECB suggests banks could also adjust the remuneration of front office staff to take failed trades into consideration. “If the trade counterparty used a settlement method that prevents banks from reducing their principal risk, they could consider decreasing their exposure limit to the counterparty or they could incentivise the counterparty to modify its FX settlement methods,” it observes. “In addition, where trades are settled in PvP, banks may lower their internal risk charge (economic capital) relative to traditional settlement on a gross basis.

The article in the newsletter closes out by stressing the ECB expects banks to “properly consider this risk in their internal capital adequacy assessment process”.