UNIVERSITY: Universidad Cooperativa De Colombia

PROGRAM: Comercio Internacional

CLASS: Finanzas Internacionales
STUDENT: Lugdy Tatiana Guerrero Loaiza

Reseña Risk

Supervisory guidance for managing risks associated with the settlement of foreign exchange
transactions

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. A
bank should have a comprehensive risk management framework to manage FX settlement-related
risks commensurate with the size, nature, complexity and risk profile of its FX activities. A bank
should have a comprehensive risk management framework for all material risks inherent to the life
cycle of an FX transaction, including principal risk, replacement cost risk, liquidity risk, operational
risk and legal risk. The framework should reflect the size, nature, complexity and risk profile of the
bank’s FX activities; provide mechanisms that properly identify measure, monitor and control
associated risks; and be integrated into the overall risk management process.

Policies and procedures the board should approve and oversee how effectively management
implements the bank’s risk policies, including policies for managing all of the risks associated with
FX settlement. The sophistication of systems should reflect the risk profile and complexity of the
bank. Timely reports should be provided to the bank’s board and senior management and include
appropriate key risk indicators and risk issues that could result in a potential loss. Selection of
appropriate pre-settlement and settlement arrangements for FX transactions a bank’s risk
management framework should include procedures to identify the most appropriate settlement
method for each type of FX transaction, given the size, nature, complexity and risk-profile of the
bank’s FX activities.

Where PVP is not practicable, a bank should manage its remaining principal risk. This will involve
setting principal risk limits that are binding; measuring expected exposures appropriately to
prevent those limits from being broken when trades are executed. In order to appropriately
calculate when the principal exposure of a specific trade will end, a bank should incorporate its
process for reconciling incoming payments and the point in time that it will identify the final or
failed receipt of the purchased currency. The bank should employ effective replacement cost risk
management tools to identify, measure, monitor and control collateralised and uncollateralised
exposures

In the liquidity risk a bank’s failure to meet its FX payment obligations in a timely manner may
impair the ability of one, or more, counterparties to complete their own settlement, which can
lead to liquidity dislocations and disruptions in the payment and settlement systems. Operational
risk the 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. A
bank’s capacity plan should include forecasting of expected and high-stress capacity needs. The
forecasts should consider the FX trading behaviour of the bank and its clients. In addition, a bank
should also work with relevant FMIs when establishing capacity policies and high-stress capacity
requirements.
UNIVERSITY: Universidad Cooperativa De Colombia
PROGRAM: Comercio Internacional
CLASS: Finanzas Internacionales
STUDENT: Lugdy Tatiana Guerrero Loaiza

Legal risk a bank should ensure that agreements and contracts are legally enforceable for each
aspect of its activities in all relevant jurisdictions. The identification of legal risk in various
jurisdictions can be accomplished through (i) legal opinions upon which a bank is entitled to rely
that are commissioned by, and addressed to, a trade organisation or an FMI of which a bank is a
member; or (ii) legal opinions provided by the bank’s in-house or external counsel who are
licensed to practice law in the jurisdictions for which they are providing such opinions.

Capital for FX transactions when analysing 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. When considering the
size and duration of FX settlement-related risks, a bank’s analysis should not be limited to the
assumption that exposures end on the contracted date of settlement.37 Therefore, the bank’s
analysis should take into account relevant deadlines for unilateral payment cancellation (which
may occur prior to settlement date) and timeframes for reconciliation processes (which may occur
after settlement date)

The paper focuses on the reduction of risks arising from FX settlement through the use of
payment-versus-payment arrangements. However, there is also a discussion of documentation
requirements. The BCBS recommends that, when documenting FX transactions, a bank should
use legally enforceable bilateral netting agreements and master netting agreements, such as the
ISDA Master Agreement, with all counterparties (where practicable). This should be supported
by legally enforceable collateral arrangements (such as the ISDA Credit Support Annex) which
specifically address issues such as collateral eligibility, haircuts, timing and frequency of margin
calls, substitution rights, thresholds and valuations

according to the approach given by the central bank Bolivia of the Origins of Central Bank
Conceras with FX Settlement Risk while the various risks associated with settling financial
transactions have long been recognized, the issues surrounding foreign exchange settlement risk
became most prominent after the Herstatt incident in 1974. In this now famous (at least to
central bankers) incident, a relatively small Germán bank, Bankhaus Herstatt, which had a large
trading book of foreign exchange transactions, was closed by its banking supervisor at the end of
the Germán banking day (approximately 10:30 am in New York).

Unfortunately, a number of institutions had made payment in Deutsche Marks in Germany to

Herstatt on foreign exchange transactions. The report notes a number of other incidents in the
decades since that have further raised concems about the cross-border, cross-time zone risks of
settlement in the modern financial environment. These included the collapse of Drexel in 1991,
the collapse of BCCI in 1991, the Soviet attempted coup in 1991, and the problems at Barings in
1995. There wore also heightened concerns in the foreign exchange community during the
recent Asian crisis with entities fearful of paying into a local market with little comfort that they
would be paid.

Mentions that it is important to consider some report recommendations Individual banks should
improve their back office payments processing, correspondent banking arrangements, obligation
UNIVERSITY: Universidad Cooperativa De Colombia
PROGRAM: Comercio Internacional
CLASS: Finanzas Internacionales
STUDENT: Lugdy Tatiana Guerrero Loaiza

netting capabilities and risk management controls sufficiently to perrnit them to (i) measure
settlement exposures properly; (ii) apply an appropriate credit control process to settlement
exposure, and (iii) reduce excessive settlement exposure for a given levelof trading.

In comparison with the previous document the Federal Reserve Bank of New York of the year
2013 issued a report where this document offers a collection of practices that, in conjunction
with Supervisory commitment letters4 and the implementation of regulatory requirements may
mitigate some of the operational risks that are specific to the FX industry. The implementation
of these practices may also help to reduce the level of risk in the FX market more generally.
Finally, acceptance of these practices may help reduce operational costs. When robust controls
are in place, less time and energy is needed to investigate and address operational problems

Finally, it can be concluded that with these documents we are informed about bank practices and
supervision with the Basel agreements although the market will continue to evolve and develop
mitigating controls, and any set of recommendations will eventually require revision, management
should consider the practices suggested here as helpful responses to recent developments in
technology, instruments, and innovations in the marketplace

It can also be taken into account that these documents give us a broad approach to intervention so
that 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.
UNIVERSITY: Universidad Cooperativa De Colombia
PROGRAM: Comercio Internacional
CLASS: Finanzas Internacionales
STUDENT: Lugdy Tatiana Guerrero Loaiza

References

Supervisory guidance for managing risks associated with the settlement of foreign exchange
transactions, Bank For international Settlements, 2013

Bank for International Settlements. Basel Committee on Banking Supervision. Operational Risk
Supporting Documentation to the New Basel Capital Accord. Basel: BIS, 2002.
Reducing FX Settlement Risk.” In The Foreign Exchange Committee 1994 Annual Report. New York:
Federal Reserve Bank of New York, 1995.