Central banks and FX risks
By Juan Foxley
Posted at Financial Times Alphaville. A Spanish version published at América Economía.
Each day, an average of USD 5.3 trillion is traded in the FX markets. That is about 11 times equivalent to what primary dealers trade in US Treasuries at a given day and more than half a year trading value of listed stocks in the NYSE.
Being the largest market in the world is enough a reason for caring about safe settlement. Also known as “Herstatt Risk”, settlement risk may reflect in the loss of principal if one party to a FX transaction would deliver the currency it owes, but would not receive the bought currency from its counterparty.
Financial market regulators and some central banks gathered around the BIS have acknowledged settlement risk as the most significant system risk to participants in the FX market, accordingly began to provide recommendations and guidelines to mitigate it, also pushing authorities to do more:
" FX settlement-related risks have been mitigated by the implementation of payment-versus-payment (PVP) arrangements and the increasing use of close-out netting and collateralization.However, substantial FX settlement-related risks remain due to rapid growth in the FX trading market.…it is crucial that banks and their supervisors continue efforts to reduce or manage the risks arising from FX settlement. In particular, the efforts should concentrate on increasing the scope of currencies, products and counterparts that are eligible for settlement through PVP arrangements." Basel Committee on Banking Supervision (2012)
The main PVP arrangement is CLS – (Continuous Linked Settlement) -which is organized as a consortium of 63 banks, regulated by the Federal Reserve Bank of NY. - CLS operates a global multi-currency cash settlement system through which settlement risk is mitigated, using a combination of payment versus payment (PvP) settlement over CLS central bank accounts. These local currency payments are executed through local real time gross settlement (RTGS) systems with finality. Daily funding obligations are multilaterally netted to materially reduce the required pay-in values, which provide enhanced liquidity efficiencies for participants.
So far, USD 2.3 trillion -(settled volume divided by two)- is executed using the CLS infrastructure. That is, 43 percent of total FX world trading.
Unfortunately, not many central banks are joining CLS. Most notable exception is the Reserve Bank of New Zealand which is a shareholder member of CLS. Also, a few other central banks appear using CLS as third parties by contracting members´services: Colombia, Denmark , Hungary, Israel, Singapore, South Africa are among them.
One natural candidate for joining CLS would be Banco de Mexico. The MXN is already one of the 17 eligible within the multi-currency settlement system and, its domestic legal arrangements are in place for proper FX trade execution.
Other central banks missing from CLS are those issuing currencies which are exhibiting relatively high and increasing international liquidity but are not yet part of the now 17-group. For example, China´s PBC and the central banks of Russia, Turkey and Brazil, among others.They would need to be proactive, twofold: in doing their legal and technical homework as it is required to win currency eligibility and, using themselves the CLS as the FX settlement vehicle. That would signal a commitment to system risk minimization while at the same time, duly protecting their international reserves against principal losses from Herstatt risk exposure.