Today, the Federal Reserve issued a Supervision and Regulation letter (SR letter) regarding the Basel Committee’s February 2013 guidance for managing risks associated with the settlement of foreign exchange transactions. The Basel Committee’s guidance sets forth seven guidelines for managing foreign exchange transaction settlement risks. Our earlier blog post on the Basel Committee’s guidance is available here. The Federal Reserve stated that large financial institutions subject to the SR letter should apply the Basel Committee’s seven guidelines to their foreign exchange activities. The SR letter provides clarifications regarding the application of the seven guidelines in the United States.
Scope of Application of the SR Letter: The SR letter applies to large financial institutions supervised by the Federal Reserve, including Large Institution Supervision Coordinating Committee (LISCC) firms, large banking organizations (LBOs) and U.S. operations of large foreign banking organizations (large FBOs), each as defined in the Federal Reserve’s SR letter 12-17 / CA letter 12-14, Consolidated Supervision Framework for Large Financial Institutions, as well as any other banking organization that engages in significant foreign exchange activities.
Type of FX Transactions Covered: The Federal Reserve stated that the SR letter applies to foreign exchange transactions that consist of two settlement payment flows, including spot transactions, forwards, swaps, deliverable options and currency swaps involving exchange of principal. It excludes instruments that involve one-way settlement payments, such as non-deliverable forwards, non-deliverable options and contracts for difference.
Clarifications Regarding the Application of the Basel Committee’s Guidance in the United States: In the SR letter, the Federal Reserve provided the following clarifications regarding the application of the Basel Committee’s February 2013 guidance in the United States.
Basel Committee Guideline 1 – Governance: A bank should have strong governance arrangements over its foreign exchange settlement-related risks, including a comprehensive risk management process and active engagement by the board of directors.
Federal Reserve Clarification: “Paragraph 3.1.8 of the [Basel Committee’s] guidance states that the board of directors of a covered institution should oversee the management of the compliance function associated with settling foreign exchange transactions. For purposes of the application of the guidelines by covered institutions, senior management should routinely communicate significant compliance matters to the board of directors. The board of directors may choose to delegate regular oversight to a single board member or a committee of the board.”
Basel Committee Guideline 2 – Principal risk: A bank should use financial market infrastructures that provide payment-versus-payment settlement to eliminate principal risk when settling foreign exchange transactions. Where payment-versus-payment settlement is not practicable, a bank should properly identify, measure, control, and reduce the size and duration of its remaining principal risk.
Basel Committee Guideline 3 – Replacement cost risk: A bank should employ prudent risk mitigation regimes to properly identify, measure, monitor, and control replacement cost risk for foreign exchange transactions until settlement has been confirmed and reconciled.
Federal Reserve Clarification: “Paragraph 3.3.7 of the [Basel Committee’s] guidance refers to transactions with affiliates. Covered institutions are encouraged to exchange variation margin for inter-affiliate transactions as a matter of sound business practice.”
Basel Committee Guideline 4 – Liquidity risk: A bank should properly identify, measure, monitor, and control its liquidity needs and risks in each currency when settling foreign exchange transactions.
Basel Committee 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 foreign exchange volumes under normal and stressed conditions.
Basel Committee 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.
Federal Reserve Clarification: “Paragraph 3.6.2 of the [Basel Committee’s] guidance states that institutions conducting business in multiple jurisdictions should identify, measure, monitor, and control for the risks arising from conflicts of laws across jurisdictions and suggests accomplishing these objectives by obtaining legal opinions from qualified internal or external counsel. The Federal Reserve does not expect a covered institution to obtain a legal opinion for every transaction; rather, management should seek legal advice that addresses standardized terms, master netting and other significant agreements, and individual transactions as appropriate.”
Basel Committee Guideline 7 – Capital for foreign exchange transactions: When analyzing capital needs, a bank should consider all foreign exchange 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.
Federal Reserve Clarification: “While the Federal Reserve acknowledges the principles set forth in Section 3.7 of the [Basel Committee’s] guidance, and in particular that all risks related to the settlement of foreign exchange transactions should be considered in determining capital needs under the applicable capital framework, the guidance does not and is not intended to modify the calculation of regulatory capital requirements for covered institutions.”
Materials: Federal Reserve, Managing Foreign Exchange Settlement Risks for Physically Settled Transactions (SR letter 13-24) (Dec. 23, 2013) available here: http://www.federalreserve.gov/bankinforeg/srletters/sr1324.pdf