Supervisory guidance for managing risks associated with the settlement of foreign exchange transactions
Since the original FX settlement risk guidance was published, the FX market has made significant strides in reducing the risks associated with the settlement of FX transactions. Substantial FX settlement-related risks remain, however, not least because of the rapid growth in FX trading activities.
The guidance provides a more comprehensive and detailed view on governance arrangements and the management of principal risk, replacement cost risk and all other FX settlement-related risks. In addition, it promotes the use of payment-versus-payment (PVP) arrangements, where practicable, to reduce principal risk. The guidance is organised into seven "guidelines" that address governance, principal risk, replacement cost risk, liquidity risk, operational risk, legal risk and capital for FX transactions. The key recommendations emphasise that a bank should:
- ensure that all FX settlement-related risks are effectively managed and that its practices are consistent with those used for managing other counterparty exposures of similar size and duration.
- reduce its principal risk as much as practicable by settling FX transactions through the use of financial market infrastrucutres (FMIs) that provide PVP arrangements. Where PVP settlement is not practicable, the bank should properly identify, measure, control and reduce the size and duration of its remaining principal risk.
- ensure that when analysing its capital needs, all FX settlement-related risks should be considered, including principal risk and replacement cost risk and that sufficient capital is held against these potential exposures, as appropriate.
- use netting arrangements and collateral arrangements to reduce its replacement cost risk and should fully collateralise its mark-to-market exposure on physically settling FX swaps and forwards with counterparties that are financial institutions and systemically important non-financial entities.