Today, the Basel Committee issued guidance for managing risks associated with the settlement of foreign exchange transactions. The guidance updates the Basel Committee’s existing supervisory guidance, which was published in 2000.
According to the Basel Committee, while its original 2000 guidance focused mainly on the principal risk element of FX settlement-related risks, the new guidance is intended to address a broader range of FX settlement-related risks. The new guidance provides more comprehensive and detailed direction on governance arrangements and the management of principal risk as well as all other FX settlement-related risks. In addition, the new guidance promotes the use of payment-versus-payment (PvP) arrangements, where practicable, to reduce principal risk.
Scope: According to the Basel Committee, the scope of the guidance only includes FX transactions that consist of two settlement payment flows, such as FX spot transactions, FX forwards, FX swaps, deliverable FX options and currency swaps involving exchange of principal. It excludes FX instruments that involve one-way settlement payments, such as non-deliverable forwards (NDFs), non-deliverable options and contracts for difference. However, the Basel Committee noted that certain parts of the guidance (e.g., those addressing replacement cost risk) will also be relevant for single-payment instruments.
Seven Guidelines: The guidance is organized into seven guidelines that address governance, principal risk, replacement cost risk, liquidity risk, operational risk, legal risk and capital for FX transactions. Below is a very high-level overview of each guideline. The Basel Committee provides detailed guidance with respect to each guideline.
Guideline 1: Governance
A bank should have strong governance arrangements over its FX settlement-related risks, including a comprehensive risk management process and active engagement by the board of directors.
Guideline 2: Principal risk
A bank should use financial market infrastructures (FMIs) that provide PvP settlement to eliminate principal risk when settling FX transactions. Where PvP settlement is not practicable, a bank should properly identify, measure, control and reduce the size and duration of its remaining principal risk.
Guideline 3: Replacement cost risk
A bank should employ prudent risk mitigation regimes to properly identify, measure, monitor and control replacement cost risk for FX transactions until settlement has been confirmed and reconciled.
Guideline 4: Liquidity risk
A bank should properly identify, measure, monitor and control its liquidity needs and risks in each currency when settling FX transactions.
Guideline 5: Operational risk
A bank should properly identify, assess, monitor and control its operational risks. A bank should ensure that its systems support appropriate risk management controls, and have sufficient capacity, scalability and resiliency to handle FX volumes under normal and stressed conditions.
Guideline 6: Legal risk
A bank should ensure that agreements and contracts are legally enforceable for each aspect of its activities in all relevant jurisdictions.
Guideline 7: Capital for FX transactions
When analyzing capital needs, a bank should consider all FX settlement-related risks, including principal risk and replacement cost risk. A bank should ensure that sufficient capital is held against these potential exposures, as appropriate.
Materials: Basel Committee, Supervisory guidance for managing risks associated with the settlement of foreign exchange transactions (Feb. 2013) available here: http://www.bis.org/publ/bcbs241.pdf