Risk PDF

Basel Committee
on Banking Supervision
Supervisory guidance for

managing risks associated
with the settlement of
foreign exchange
transactions
February 2013
This publication is available on the BIS website (www.bis.org).
© Bank for International Settlements 2013. All rights reserved. Brief excerpts may be reproduced or
translated provided the source is cited.
ISBN 92-9131-915-5 (print)

ISBN 92-9197-915-5 (online)
Contents
Overview of Guidelines .......................................................................................................... 1

Abbreviations ......................................................................................................................... 2
Executive summary ............................................................................................................... 3
Introduction ............................................................................................................................ 5
Purpose, scope and structure ....................................................................................... 5
Background .................................................................................................................. 5
Implementation by supervisors ..................................................................................... 6
Guideline 1: Governance ....................................................................................................... 7
Guideline 2: Principal risk .................................................................................................... 11
Guideline 3: Replacement cost risk ...................................................................................... 15
Guideline 4: Liquidity risk ..................................................................................................... 17
Guideline 5: Operational risk ................................................................................................ 20
Guideline 6: Legal risk ......................................................................................................... 23
Guideline 7: Capital for FX transactions ............................................................................... 25
Annex: FX settlement-related risks and how they arise ........................................................ 27
Glossary .............................................................................................................................. 32
Bibliography ......................................................................................................................... 37
Members of the Joint BCBS-CPSS Working Group on Foreign Exchange Settlement Risk . 38
Supervisory guidance for managing risks associated with the settlement of foreign exchange transactions
Overview of Guidelines
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 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 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.
Supervisory guidance for managing risks associated with the settlement of foreign exchange transactions 1
Abbreviations
BCBS Basel Committee on Banking Supervision

CCP Central counterparty
CLS Continuous linked settlement
CPSS Committee on Payment and Settlement Systems
FMI Financial market infrastructure
FX Foreign exchange
ISDA International Swaps and Derivatives Association, Inc.
NDF Non-deliverable forward
Non-PVP Non-payment-versus-payment
PVP Payment-versus-payment
RTGS Real-time gross settlement
STP Straight-through processing
2 Supervisory guidance for managing risks associated with the settlement of foreign exchange transactions
Executive summary
Since the previous supervisory guidance was published in 2000, the foreign exchange (FX)
market has made significant strides in reducing the risks associated with the settlement of FX
transactions. These risks include principal risk, replacement cost risk, liquidity risk,
operational risk and legal risk. 1 Such 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 collateralisation. However, substantial FX settlement-related risks
remain due to rapid growth in FX trading activities. In addition, many banks underestimate
their principal risk 2 and other associated risks by not taking into full account the duration of
exposure between trade execution and final settlement. While such risks may have a
relatively low impact during normal market conditions, they may create disproportionately
larger concerns during times of market stress.
Therefore, 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 counterparties that are eligible for
settlement through PVP arrangements.
This guidance expands on, and replaces, the Supervisory guidance for managing settlement
risk in foreign exchange transactions published in September 2000 by the Basel Committee
on Banking Supervision (BCBS). The revised 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. It also promotes the use of
PVP arrangements, where practicable, to reduce principal risk. The BCBS expects banks
and national supervisors to implement the revised guidance in their jurisdictions, taking into
consideration the size, nature, complexity and risk profile of their banks’ FX activities.
This 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 the following:
• 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.
• A bank should reduce its principal risk as much as practicable by settling FX
transactions through the use of FMIs that provide PVP arrangements. Where PVP
settlement is not practicable, a bank should properly identify, measure, control and
reduce the size and duration of its remaining principal risk.
• A bank should ensure that when analysing 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.
• A bank should use netting arrangements where netting is legally enforceable and
collateral arrangements to reduce its replacement cost risk and should fully
collateralise its mark-to-market exposure on physically settling FX swaps and
1
The Glossary section contains a definition for each of these risks.
2
This guidance uses the term, “principal risk”, to mean the risk of outright loss of the full value of a trade
resulting from counterparty failure (ie a bank pays away the currency being sold, but fails to receive the
currency being bought). Principal risk is sometimes referred to as “Herstatt Risk”.
forwards with counterparties that are financial institutions and systemically important
non-financial entities.
Introduction
Purpose, scope and structure
2.1 The purpose of this document is to provide updated guidance to supervisors and the
banks they supervise on approaches to managing the risks associated with the settlement of
FX transactions. This guidance expands on, and replaces, the BCBS’s Supervisory guidance
for managing settlement risk in foreign exchange transactions published in September 2000.
The BCBS expects banks and national supervisors to implement the revised guidance in
their jurisdictions, taking into consideration the size, nature, complexity and risk profile of the
bank’s FX activities.
2.2 This guidance provides a comprehensive and detailed view of the key risks that
arise from a foreign exchange trade during the period between trade execution and final
settlement (ie during the pre-settlement and settlement periods). The revised guidance
addresses governance, principal risk, replacement cost risk, liquidity risk, operational risk,
legal risk and capital for FX transactions. The revised guidance also addresses the use of
PVP settlement mechanisms, which are now far more widespread than in 2000.
2.3 The guidance is based on the principle that banks should manage FX settlement-
related risks in a way that is similar to the management of equivalent risks from their other
activities, while taking into account any features that are specific to FX.
2.4 The scope of the guidance only includes FX transactions that consist of two
settlement payment flows. This includes 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. 3
Background
2.5 The risk that arises from the settlement of FX transactions has long been a concern
of banking supervisors and central banks. The failure of Bankhaus Herstatt in 1974
highlighted the nature and extent of the systemic risks that can be associated with FX
settlement. In 1996, the CPSS published a thorough analysis of principal risk along with a
comprehensive strategy to reduce the serious systemic risk implications. 4 This was followed
by a progress report in 1998 5 and the publication of the BCBS’s guidance in 2000.
2.6 Since 2000, substantial progress has been made in mitigating FX settlement-related
risks. The use of FMIs that provide PVP settlement mechanisms, designed to virtually
eliminate principal risk, has been particularly important in achieving that progress. However,
a survey of FX settlement practices conducted by the Committee on Payment and
Settlement Systems (CPSS) in 2006 6 demonstrated that further action is needed by banks,
industry groups and central banks. In addition, while FX settlement via PVP methods now
account for the greater part of FX trading by value, many banks do not have a good
3
Nevertheless, certain parts of the guidance (eg dealing with replacement cost risk) will also be relevant for
single-payment instruments.
4
See Settlement risk in foreign exchange transactions, CPSS, March 1996.
5
See Reducing foreign exchange settlement: a progress report, CPSS, July 1998.
6
See Progress in reducing foreign exchange settlement risk, CPSS, May 2008 (which includes the results of
the 2006 survey).
understanding of the potential residual risks, including replacement costs and liquidity risks.
The banks’ methods of identifying, measuring, monitoring and controlling FX settlement-
related risks are not always acceptably robust. Moreover, growth in the size of the FX market
since 2000 suggests that the absolute value settled by potentially riskier non-PVP methods
may not be less than before PVP methods existed.
Implementation by supervisors
2.7 Banking supervisors should incorporate the guidelines in this document into their
supervisory framework for banks under their authority. As part of their ongoing supervisory
activities, they should assess whether each bank that is engaging in FX trading is meeting
the guidelines, taking into consideration the size, nature, complexity and risk profile of its
activities.
2.8 In cases where supervisors determine that a bank’s management of FX settlement-

related risks is not adequate, given its size, nature, complexity and specific risk profile, they
should take appropriate action to correct the situation. If needed, supervisors should consider
available supervisory enforcement tools that are suitable to the particular circumstances of a
bank and its operating environment.
2.9 Supervisors should also assess whether a bank is making appropriate use of PVP
settlement, pre-settlement netting and other risk-reduction arrangements. For FX
transactions that do not settle via PVP, supervisors should also place special emphasis on
encouraging a bank to minimise the size and duration of its principal risk and to conduct
timely reconciliation of payments received.
2.10 Supervisors should assess whether a bank is appropriately incorporating principal

risk, replacement cost risk and all other FX settlement-related risks when analysing its capital
needs. In cases where supervisors determine that FX settlement-related risks are not
appropriately incorporated, they should take appropriate measures, including corrective
action.
2.11 To fully address FX settlement-related risks, banks’ incentives, business practices

and infrastructures must be properly aligned. This guidance addresses business practices
such as risk management and incentives gained from analysing capital needs. In addition,
investment in infrastructures that facilitate PVP settlement across many participants,
currencies and products can play a significant role in the elimination of principal risk and
other FX settlement-related risks. Since industry participation is critical to the development
and use of such market infrastructures, supervisors should encourage such efforts, where
practicable.
2.12 The BCBS and CPSS intend to monitor banks’ and supervisors’ progress in
implementing this guidance, and will commence a review of that progress in 2015.
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. 7
Key considerations
1. A bank should have strong governance arrangements that ensure all FX settlement-
related risks are properly identified, measured, monitored and controlled on a firm-
wide basis.
2. 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. This framework should cover all material risks including
principal risk, replacement cost risk, liquidity risk, operational risk and legal risk. The
framework should include policies and procedures, limit structures, management
information systems and key risk indicators, fails management, escalation
procedures and an internal audit and compliance program.
3. The risk management framework should also ensure that all risks associated with
the selection of specific pre-settlement and settlement arrangements used by a bank
are properly identified, measured, monitored and controlled.
Strong governance of FX settlement-related risks

3.1.1 The board of directors is ultimately responsible for ensuring that the bank has strong
governance arrangements that require all FX settlement-related risks be properly identified,
measured, monitored and controlled on a firm-wide basis. This includes approving and
overseeing the bank’s strategic objectives, risk appetite statement 8 and corporate
governance structure. The board oversees senior management and ensures that
management’s actions to monitor and control FX settlement-related risks are consistent with
the risk appetite, strategy and policies previously approved by the board. These efforts
should be supported by appropriate reporting to ensure that the board receives sufficient and
timely information regarding how the bank is managing its FX settlement-related risks. The
bank’s overarching governance framework should include a comprehensive program of
internal controls to measure these risks.
Comprehensive risk management framework

3.1.2 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.
7
With regard to governance structures, see Principles for enhancing corporate governance, BCBS, October
2010, paragraph 12.
8
“Risk appetite” reflects the level of aggregate risk that the bank’s board of directors is willing to assume and
manage in pursuit of its objectives. For the purpose of this document, the terms, “risk appetite” and “risk
tolerance,” are used synonymously. See Core principles for effective supervision, BCBS, September 2012.
Policies and procedures
3.1.3 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. Policies and procedures should be comprehensive, consistent with relevant laws,
regulations and supervisory guidance and provide an effective system of internal controls.
Policies and procedures should be clearly documented. Once established, policies should be
periodically reviewed for adequacy based on changes to financial markets and internal
business strategies.
Limit structure
3.1.4 A bank should set formal, meaningful counterparty exposure limits for FX trading
and settlement that include limits for principal risk and replacement cost risk. In particular, the
size and duration of principal exposures that arise from non-PVP settlements should be
recognised and treated equivalently to other counterparty exposures of similar size and
duration. Limits consistent with the bank’s risk appetite should be established by the credit
risk management department, or equivalent, on a counterparty basis. Usage should be
controlled throughout the day to prevent trades that would create principal and replacement
cost exposures that exceed these limits. Exceptions to established limits should be approved
in advance (prior to trading) by the appropriate authority in accordance with established
policies and procedures.
Management information systems and key risk indicators

3.1.5 A bank should have sufficiently robust systems to capture, measure and report on
FX settlement-related exposures on a bank-wide basis, across business lines and
counterparties. 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.
Fails management
3.1.6 A bank should ensure that its framework identifies FX fails and captures the full
amount of the resulting FX settlement-related risks as soon as practicable, to allow senior
management to make appropriate judgements regarding the nature and severity of the
exposure.
Escalation procedures
3.1.7 A bank should clearly define, in its policies, the nature and types of incidents that
would constitute issues requiring escalation to, and approval by, senior management or the
board. There should be clear and detailed escalation policies and procedures to inform
senior management and the board, as appropriate, of potential FX issues and risks in a
timely manner, and seek their approval when required. This should include, but not be limited
to, exceptions to established limits and fails management.
Internal audit and compliance program

3.1.8 A bank should have an independent and effective internal audit function that can
evaluate the effectiveness of management’s efforts to control or mitigate the risks associated
with settling FX transactions. Internal audit should have an independent reporting line to the
bank’s board or audit committee of the board, audit staff with the necessary expertise and
experiences on the subject, and sufficient status within the bank to ensure that senior
management responds appropriately to findings and recommendations. In addition, a bank
should have an effective compliance function that manages compliance-related matters
associated with settling FX transactions. The board should oversee the management of the
compliance function.
Selection of appropriate pre-settlement and settlement arrangements for FX
transactions
3.1.9 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. In making this evaluation, a bank
should carefully measure the size and duration of its principal exposures. This framework
should assess all available settlement methods and their efficacy at reducing or eliminating
principal risk and other FX settlement-related risks. These implications need to be identified,
assessed and incorporated into the bank’s decision-making process. Once an appropriate
settlement method is chosen, a bank should properly manage all FX settlement-related risks
associated with that method. Where PVP arrangements are available, but a bank or its client
has chosen not to use them, the bank should periodically reassess its decision. (See Annex:
FX settlement-related risks and how they arise, Section C, for descriptions of available
settlement methods and their respective risk implications).
Selection of an FMI
3.1.10 When choosing to use or participate in an FMI, a bank should conduct robust initial
due diligence to assess the associated risks. The initial due diligence should include a review
of legal, operational, credit and liquidity risks associated with the use of an FMI and its
participants and controls. A bank should have a thorough understanding of an FMI’s rules
and procedures, as well as any responsibilities and FX settlement-related risks that it may
assume through its use or participation, directly or indirectly. A bank must ensure that it has
the appropriate policies, procedures and internal control structure to adequately manage its
risks and to fulfil its responsibilities to the FMI and its clients. Once a bank chooses to use or
participate in an FMI, it should conduct periodic monitoring to identify significant changes to
the FMI’s processes or controls that may affect its risk exposures. If significant changes
occur, the bank should update its risk analysis, as appropriate. To the extent that an FMI is
subject to the Principles for financial market infrastructures, 9 the bank should refer to
available disclosures based on the principles when conducting its own due diligence and
periodic monitoring of the FMI.
Selection of a correspondent bank

3.1.11 A bank’s risk management framework should include policies and procedures for
evaluating the risks and benefits of using one or more correspondent banks to settle its FX
transactions in each currency. The framework should consider the potential size, form and
maturity of the bank’s exposure to its correspondents; and include an evaluation of each
correspondent’s financial condition and the risk profile of each correspondent’s jurisdiction. It
should include an assessment of any credit, liquidity, operational and legal risks associated
with using correspondent banking services. The framework should provide for periodic
reviews of the bank’s correspondent banks and have procedures in place to mitigate any FX
settlement-related risks that may arise.
Dependence on other institutions

3.1.12 A bank should consider its level of dependence on other institutions for settling its
FX transactions. It should assess the potential impact of disruption and mitigate the FX
settlement-related risks, as appropriate. Such risk mitigants may include establishing dual or
backup correspondent or settlement banks to make payments, or joining an FMI directly. The
9
See Principles for financial market infrastructures, CPSS/IOSCO, April 2012.
appropriate method should consider costs, testing arrangements, switching time, time to on-
board, legal agreements, service fees, etc.
Guideline 2: Principal risk
A bank should use 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.
Key considerations
1. A bank should eliminate principal risk by using FMIs that provide PVP settlement,
where practicable.
2. Where PVP settlement is not practicable, principal risk should be properly identified,
measured, monitored and controlled. In particular, measurement of exposure should
not underestimate size and duration and should be subject to binding ex-ante limits
and other controls equivalent to other credit exposures of similar size and duration
to the same counterparty.
3. A bank should reduce the size and duration of its principal risk as much as
practicable.
Eliminating principal risk using PVP settlement

3.2.1 A bank should eliminate principal risk by using FMIs that provide PVP settlement,
where practicable. In addition to a number of regional settlement arrangements, there are
also mechanisms that provide global PVP settlement. PVP arrangements are designed to
eliminate principal risk, but will not eliminate a bank’s replacement cost risk or liquidity risk. A
bank should identify and manage these risks effectively.
3.2.2 While a bank should maximise its use of PVP, it may still have trades that cannot be
settled through a PVP arrangement (eg certain same day trades, trades in certain products
or currencies, trades with counterparties not eligible for PVP settlement, etc). To further
reduce principal risk, the bank should support initiatives to have such trades become eligible
for settlement through available PVP arrangements.
3.2.3 A bank may access the services of a PVP arrangement as a direct participant or as
an indirect participant. A bank that is an indirect participant, or third party, should determine
whether the settlement processes of the direct participant, or third party service provider
(including any “internalised” or “on-us” settlement processes it may use), creates principal
risk exposure. Principal risk exposures may occur between the bank and the direct
participant, or between the bank and its counterparty (in internalised settlement). 10 If principal
risk exists, then the bank should manage it accordingly.
Controlling remaining principal risk

Setting and using limits
3.2.4 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; and
10
Principal exposure related to internalised settlement occurs where execution or authorisation of the relevant
entry in the on-us account denominated in the currency being sold is not conditional upon execution or
authorisation of the corresponding entry in the on-us account in the currency being bought (See Progress in
reducing foreign exchange settlement risk, CPSS, May 2008 – Box 2, Settlement methods).
monitoring the subsequent status of the trades to take prompt action when problems arise.
Management of principal risk should be fully integrated into a bank’s overall risk
management process.
3.2.5 A bank should ensure that principal risk to a counterparty is subject to prudent limits.
Principal risk should be subject to an adequate credit control process, including credit
evaluation and a determination of maximum exposure to a particular counterparty.
Counterparty exposures arising from principal risk should be subject to the same procedures
used to set limits on other exposures of similar duration and size to that counterparty.
3.2.6 The trading limits applied by a bank should be binding, namely, usage should be
monitored and controlled throughout the day to prevent trades that would create exposures
during the settlement process that would exceed the limit. 11 Where a bank is acting as a
prime broker, it should have ex-ante processes in place to prevent client trades from creating
exposures that would exceed the limit. 12 When a decision is made to allow a client to exceed
a limit, appropriate approval should be obtained. A bank that exceeds its principal risk limit
with a particular counterparty should reduce its exposure as soon as is practicable.
3.2.7 To ensure that the limits are binding, a bank should use an ex-ante process that
updates and reports exposure on a timely basis, preferably as each trade is executed. If a
bank has limited capability to update and report exposure on a timely basis, then the bank
needs to have effective post-trade risk management controls to minimise limit breaches. 13
Measuring expected principal risk

3.2.8 For a bank to estimate the expected principal risk that will arise from a trade during
its settlement process and to determine whether the counterparty limit will be exceeded, it
needs to accurately measure when that exposure will begin and when that exposure will end.
This requires the bank to know the relevant unilateral cancellation deadline for the currency it
sold and when the incoming payment for the currency it bought will be received with finality
and is reconciled. A bank will also need to determine whether it is appropriate to use
approximate, rather than exact, measures of exposure that may arise during a trade’s
settlement.
(a) Unilateral payment cancellation deadlines

3.2.9 A bank’s principal risk exposure to its counterparty begins when a payment order on
the currency it sold can no longer be recalled or cancelled with certainty – this is known as
the “unilateral payment cancellation deadline.” 14 A bank should reduce the duration of its
exposures by having the capability to unilaterally cancel payment instructions as late as
11
Frequent requests for intra-day limit increases by the same client should prompt the bank to assess its
approved risk appetite for that client and the additional risk that is being assumed.
12
For example, prime brokers typically support high-frequency trading clients by extending credit sponsorship
and access to various electronic FX trading platforms. Given the short time frames associated with high-
frequency trading activities, risk positions by high-frequency traders can accumulate rapidly under the name of
a prime broker; thereby, raising the need for the prime broker to closely monitor and control its clients’
activities. For more information about high-frequency trading and FX prime brokerage relationships, see High-
frequency trading in the foreign exchange market, The Markets Committee of the Bank for International
Settlements, September 2011.
13
For example, if a settlement limit is breached for a particular value date, auto-pricing of trades is prevented
from executing further trades for that value date.
14
Since this deadline may be one or more business days before the settlement date, this risk can last for a
significant period of time.
practicable. This might require changes to systems and processes used to process internal
payments. The exposure ends when the bank receives the purchased currency with finality.
The duration of principal risk can vary depending on the currency pair being settled and the
correspondent banking arrangements used by the bank and its counterparty.
3.2.10 A key factor in determining a unilateral payment cancellation deadline is the latest
time a correspondent guarantees to satisfy a cancellation request (the guaranteed cut-off
time). Service level agreements should identify this cut-off time. In instances where an
agreement may not specify a guaranteed cut-off time or a bank may not have a written
agreement, the bank and its correspondent should establish a specific cut-off time as late as
practicable. 15,16
3.2.11 A bank should be able to identify and halt individual payments up to the cut-off times
(regardless of time zone issues) guaranteed by its correspondents or the payment system in
which it participates without disrupting the processing of other outgoing payments. 17 Where a
bank’s internal operational factors limit the bank’s ability to do so, its effective unilateral
payment cancellation deadline may be earlier than the guaranteed correspondent cut-off
time. In some cases, the unilateral payment cancellation deadline may actually be earlier
than the time the payment order is normally sent to the correspondent. This could occur, for
example, if cancelling an internally queued, but still unsent, payment order requires manual
intervention. To ensure effective processing consistent with unilateral payment cancellation
deadlines under stress, a bank should periodically test with its branches and payment
correspondents.
(b) Reconciling incoming payments

3.2.12 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. To avoid
underestimating exposures, the bank should assume that funds have not been received until
credit to its correspondent bank (nostro agent) account has been confirmed and the bank
has determined which trades have successfully settled and which have failed to settle.
3.2.13 A bank should minimise the period of uncertainty (ie the time between actual final
receipt and reconciliation) by arranging to receive timely information on final payment receipt
from its correspondent bank.
(c) Use of approximation techniques

3.2.14 When calculating expected principal risk using approximation methods, a bank
should not underestimate the risk. 18 This requires that the bank identify the relevant unilateral
payment cancellation deadlines and reconciliation process timelines for each currency pair.
15
Note that unilateral delay in sending payment instructions may increase the correspondent’s operational risk
(eg incorrect execution of payment instructions).
16
If a bank acts as its own paying agent (eg if the bank is a direct participant in the payment system for the sold
currency), then its unilateral cancellation deadline for that currency reflects its internal payment processing
rules and procedures and those of the relevant payment system.
17
In addition to impacting a universal cancellation deadline, disruption of outgoing payments may impair a
bank’s ability to make timely payments to its counterparties.
18
For example, as noted in Progress in reducing foreign exchange settlement risk (CPSS, 2008), the most
commonly cited estimation method used is the “calendar day” method, where banks measure their daily
(d) Fails
3.2.15 Effective monitoring of failed transactions is crucial for measuring and managing
principal risk, as unexpected fails cause exposures to be higher than predicted. A bank
should have a framework that monitors fails and properly accounts for them in its exposure
measures.
Reducing the size of remaining principal risk

3.2.16 Where PVP settlement is not used, a bank should reduce the size of its principal risk
as much as practicable. A bank could use obligation netting to reduce the size of its principal
risk exposures. Depending on trading patterns, legally binding obligation netting permits a
bank to offset trades to a counterparty so that only the net amount in each currency is paid or
received. To allow exposures to be measured on a net basis, netting arrangements should
be legally sound and enforceable in all relevant jurisdictions.
3.2.17 A bank should use legally enforceable bilateral netting agreements and master
netting agreements (eg ISDA) 19 with all counterparties, where practicable. The netting
agreements 20 should contain legally enforceable provisions for close-out netting and
obligation netting. (See Annex: FX settlement-related risks and how they arise, Section C, for
descriptions of netting arrangements).
3.2.18 If a counterparty’s chosen method of settlement prevents a bank from reducing its
principal risk (eg a market participant does not participate in PVP arrangements or does not
agree to use obligation netting), then the bank should consider decreasing its exposure limit
to the counterparty or creating incentives for the counterparty to modify its FX settlement
methods.
settlement exposures as the total receipts coming due on settlement date. Such a method can lead to
underestimation of risk.
19
Master netting agreements are not valid in all jurisdictions. If a bank trades in a jurisdiction that does not
support master netting agreements, then it should manage FX settlement-related principal risk appropriately
(usually gross).
20
A bank should understand the implications of not having a netting agreement with a counterparty (eg where
FX trading is restricted to very short tenors) and manage this risk accordingly.
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.
Key considerations
1. Replacement cost risk should be properly identified, measured, monitored and
controlled. In order to ensure that the size and duration of exposures are not
underestimated, a bank should identify and assess the impact of its assumptions
regarding timing of FX settlement.
2. A bank should use netting agreements to reduce its replacement cost risk in
jurisdictions where netting is legally enforceable.
3. A bank should use legally enforceable collateral arrangements and should have an
explicit policy on margin, eligible collateral and haircuts to reduce replacement cost
risk. A bank should exchange (ie both receive and deliver) the full amount of
variation margin necessary to fully collateralise the mark-to-market exposure on
physically settled FX swaps and forwards with counterparties that are financial
institutions and systemically important non-financial entities. Variation margin should
be exchanged with sufficient frequency (eg daily) with a low minimum transfer
amount.
Identifying, measuring, monitoring and controlling exposures

3.3.1 A bank should employ effective replacement cost risk management tools to identify,
measure, monitor and control collateralised and uncollateralised exposures.
Setting and using limits

3.3.2 Meaningful limits on exposures, including replacement cost risk, are an integral part
of an effective risk-management framework. Replacement cost risk limits should be
established by maturity buckets to control current exposure and potential future
exposure. 21,22 Banks should consider other measures to further control the replacement cost
risk, such as regularly measuring stress test results against limits.
Duration of replacement cost risk and the timing of settlement

Reconciliation of settlement
3.3.3 Until the final settlement of FX transactions is confirmed and reconciled, a bank
cannot be certain that it is no longer exposed to replacement cost risk for those transactions.
In order to avoid underestimation of potential replacement cost risk, a bank should assume
that the exposure begins at trade execution and continues until final settlement of the
transaction has been confirmed and reconciled.
21
The potential future exposure sets an upper bound on a confidence interval for future credit exposure related
to market prices over time.
22
The methodology used to calculate the FX exposure will depend on whether the bank uses an agreed-upon
internal model or the standardised approach. Limits should be assigned accordingly.
Close-out netting and gross settlement
3.3.4 A bank should identify and assess the impact of its assumptions regarding the
timing and nature of settlement when measuring replacement cost risk under a close-out
netting agreement. For example, a bank with close-out netting agreements might measure
and manage replacement cost risk on a bilateral net basis with the assumption that either all
transactions with a single counterparty due to settle on a particular day will settle or none will
settle. Since payments to settle FX transactions may be made at any time, from the opening
of business in the Asia-Pacific region to the close of business in the Americas, this
assumption may be faulty. 23 Therefore, the bank should manage its replacement cost risk
according to actual settlement times to avoid underestimating its risk.
Netting and collateral arrangements

Netting
3.3.5 A bank should use bilateral netting agreements and master netting agreements with
all counterparties in jurisdictions where netting is legally enforceable. The netting agreements
should include provisions for close-out netting and obligation netting. Close-out netting
reduces risk and provides legal clarity regarding a surviving bank’s claims and/or obligations
with respect to a defaulted counterparty. It mitigates the risk of being forced to make
payments of gross principal, or of gross marked-to-market losses, to the defaulted
counterparty, while the defaulted counterparty’s obligations become unsecured liabilities in a
bankruptcy process.
Collateral arrangements
3.3.6 A bank should use legally enforceable collateral arrangements (eg ISDA credit
support annexes) to mitigate its replacement cost risk. Collateral arrangements should
describe the parties’ agreement on all aspects of the margining regime, including collateral
eligibility, timing and frequency of margin calls and exchanges, thresholds, valuation of
exposures and collateral and liquidation.
3.3.7 A bank should exchange (ie both receive and deliver) the full amount of variation
margin necessary to fully collateralise the mark-to-market exposure on physically settling FX
swaps and forwards with counterparties that are financial institutions and systemically
important non-financial entities. Variation margin should be exchanged with sufficient
frequency (eg daily) with a low minimum transfer amount. Margin would be permitted, but not
required, for transactions with sovereigns, central banks, multilateral development banks or
the Bank for International Settlements. Transactions between a firm and its affiliates should
be subject to appropriate regulation in a manner consistent with each jurisdiction’s legal and
regulatory framework. Collateral management policies and procedures should at a minimum
address: (a) collateral eligibility, (b) collateral substitution; and (c) collateral valuation and
should be reviewed on a periodic basis.
3.3.8 Non-cash collateral assets should be highly liquid in order to be liquidated in a

reasonable amount of time to cover mark-to-market losses. Valuations of collateral should be
appropriately calibrated to reflect underlying risks during both normal and stressed market
conditions. More stable and conservative/higher haircuts can be expected to moderate the
procyclical impact of these arrangements.
23
For instance, even if a bank is “flat” with a particular counterparty from a bilateral net replacement cost
perspective, it is possible that all of its “out-of-the-money” trades could settle, while all of its “in-the-money”
trade could fail.
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.
Key considerations
1. A bank should ensure that its liquidity needs and risks are appropriately represented
in the bank’s liquidity risk management framework. 24
2. A bank should identify, measure, monitor and control its liquidity needs in each
currency and have sufficient liquidity resources to meet those needs in normal and
stressed conditions.
3. A bank’s liquidity risk management framework should incorporate the liquidity risks
that arise from its use of, and the various roles it may play in, an FMI, as well as
from its use of correspondent banks.
Liquidity risk management framework

3.4.1 A bank should appropriately manage its liquidity needs and risks to ensure that it is
able to meet its FX payment obligations on time. 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.
3.4.2 A bank should manage its overall liquidity needs and risks in accordance with
existing international supervisory guidance. 25 A bank’s liquidity needs and risks should be
appropriately represented in a bank’s liquidity risk management framework. The framework
should address how the bank’s liquidity needs and risks in each currency will vary based on
the chosen method of settlement. In addition, the framework should incorporate stress tests
using various severe, but plausible, scenarios.
Identify and manage liquidity needs

3.4.3 A bank should identify, measure, monitor and control its liquidity needs in each
currency, taking into consideration the settlement method and applicable netting
arrangements. A bank should be able to prioritise time-specific and other critical payment
obligations to meet payment deadlines. This is particularly important for a bank that uses an
FMI to settle its FX obligations. While settlement through an FMI can reduce a bank’s overall
liquidity needs, it can also place high demands on a bank to make time-critical payments to
settle its FX transactions. In order to meet its payment obligations in a timely manner, a bank
should maintain sufficient available liquid resources and have the ability to mobilise those
resources, as required. A bank should identify and manage the timeframes required to
mobilise different forms of collateral, including collateral held on a cross-border basis.
24
This guideline focuses on funding liquidity risk. Funding liquidity risk is the risk that the firm will not be able to
efficiently meet expected and unexpected current and future cash flow and collateral needs without affecting
either daily operations or the financial condition of the firm. Market liquidity risk is the risk that a firm cannot
easily offset or eliminate a position at the market price due to inadequate market depth or disruption.
25
See Principles for sound liquidity risk management and supervision, BCBS, September 2008 and Basel III:
International framework for liquidity risk measurement, standards and monitoring, BCBS, December 2010.
Impact of FX settlement failure
3.4.4 A bank may face a significant liquidity shortfall if a counterparty fails to deliver a leg
of an FX transaction (the purchased currency) on time. This situation may be exacerbated in
a non-PVP settlement process, whereby the bank has already paid away the sold currency
and cannot use those funds as collateral or to swap outright to obtain the needed counter-
currency. A bank should account for these risks in its liquidity risk management framework
and develop contingency plans to address possible liquidity shortfalls.
3.4.5 A bank may settle its FX payment obligations based on a bilateral or multilateral net
position in each currency (position netting) even though the underlying obligations remain
gross from a legal perspective. When this is the case, a bank should understand and
address the risk that its liquidity needs could change materially following a settlement
disruption. In particular, the failure of a counterparty or a settlement disruption in an FMI
could lead to a scenario where a bank’s net liquidity needs increase significantly by reverting
to gross liquidity needs.
Liquidity risks associated with an FMI

3.4.6 A bank that settles its FX obligations through an FMI should assess the FMI’s rules
and procedures to identify potential liquidity risks. For example, a bank should understand an
FMI’s rules for rescinding trades and the associated liquidity impact on the bank. In addition,
a bank may use certain liquidity-saving mechanisms to reduce its funding needs and should
assess and manage its risk resulting from the absence of such mechanisms. 26 Further, as
noted above, a participant failure or a disruption to the operations of an FMI may change a
bank’s liquidity requirements. For example, if a participant fails to make payment or
settlement is disrupted, then the remaining participants may be required to make unexpected
funding payments to settle their transactions. A bank should incorporate these risk scenarios
into its liquidity stress tests and make appropriate adjustments to its liquidity management
policies, procedures and contingency funding plans.
3.4.7 A bank may have additional responsibilities associated with being an FMI member
that should be considered in its liquidity risk management framework. For example, a bank
may provide third party settlement services, correspondent banking services or credit to its
customers to facilitate FMI settlement. Further, a bank may also be a liquidity provider to an
FX settlement FMI. 27 If an FMI needs to draw on its liquidity facilities, a provider bank may
experience liquidity stresses resulting from the combination of its own FX obligations and the
needs of the FMI. As these situations are likely to occur during periods of significant market
stress, a bank should incorporate these risk scenarios in its liquidity stress tests. In these
scenarios, a bank should consider that normal funding arrangements may not be available.
Liquidity risks associated with the use of a correspondent bank

3.4.8 When choosing to settle FX activities through a correspondent bank (nostro agent),
a bank should ensure that the arrangement allows it to meet its FX obligations in each
currency on a timely basis under varying circumstances. For example, a bank should assess
the impact of a correspondent bank restricting the provision of intraday credit on its ability to
meet its FX obligations, particularly if cross-border collateral would need to be mobilised to
facilitate settlement. In addition, a bank should recognise the potential for operational or
financial disruptions at its correspondent bank to disrupt its own liquidity management. A
bank should assess such risks and consider appropriate mitigants, such as establishing
26
In/out swaps (see Glossary) are examples of liquidity-saving mechanisms.
27
Many FMIs rely on liquidity from members to effect settlement.
alternative settlement arrangements to ensure it can continue to meet its FX obligations on
time. 28
28
See Principles for Sound Liquidity Risk Management and Supervision, BCBS, September 2008 – Principle 8.
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.
Key considerations
1. A bank should ensure that its operational risks are appropriately represented in the
bank’s operational risk management framework.
2. A bank should maximise the use of straight-through processing (STP) and other
effective means to control operational risks.
3. A bank should confirm trades in a timely manner, using electronic methods and
standard settlement instructions, 29 where practicable.
4. A bank should have a robust capacity management plan to ensure that its systems
have sufficient capacity and scalability to handle increasing and high-stress FX
trading volumes. The plan should include the timely monitoring of trading volumes
and capacity utilisation of key systems to prevent it from approaching critical levels.
A bank that engages in high-frequency trading, or has prime brokerage clients that
engage in such activity, should monitor trading volumes in real-time and assess the
potential for large FX trading spikes.
5. A bank should have robust business resiliency and continuity plans to manage its
operational risks and complete its FX settlement obligations.
Operational risk management framework

3.5.1 A bank should manage its operational risks in accordance with current international
supervisory guidance. 30 A bank should establish an operational risk management framework
that identifies, assesses, monitors and controls a bank’s operational risks. The framework
should address the accuracy, capacity and resiliency of a bank’s operational processes and
systems for FX settlement. A bank should periodically reassess its operational risks,
including risks that stem from changes in its FX portfolio (eg new products).
3.5.2 A bank’s operational risks can arise from deficiencies in information systems,
internal processes, personnel or disruptions from external events. These risks can lead to
inadequacies in the accuracy, capacity and resiliency of a bank’s operations and cause
delays or errors in trading data or confirmation of FX trades. Further, operational risks can
lead to losses resulting from the bank’s failure to meet obligations on time, and create or
exacerbate other risks (eg principal risk, replacement cost risk, liquidity risk and reputational
risk).
Straight-through processing (STP)

3.5.3 A bank should maximise the use of STP by employing systems that automatically
feed transactions, adjustments and cancellations from trade execution systems to other
29
Standard settlement instructions may also be referred to as “standing settlement instructions”.
30
See Principles for the sound management of operational risk, BCBS, June 2011.
internal systems, such as operations and credit-monitoring systems. STP helps to ensure
that data is disseminated quickly, accurately and efficiently throughout the bank, and allows
for effective monitoring and control of risks from trade execution to settlement. For example,
STP can facilitate the timely confirmation of trades with counterparties and eliminate errors
from manual processing. Maximising the use of STP, however, does not fully eliminate
operational risk. In addition, STP systems require monitoring and sufficient capacity and
scalability. In the event that STP systems are disrupted, a bank should have contingency
procedures to continue its operations.
Trade confirmation and affirmation31

3.5.4 A bank should establish processes and procedures that allow it to confirm or
positively affirm FX trades as soon as practicable after execution to reduce the potential for
losses from market risk or other sources. Where practicable, a bank should use electronic
methods and standard settlement instructions to maximise the use of STP and allow for
prompt confirmation and affirmation. Escalation procedures should be in place to resolve
unconfirmed transactions. Trade confirmations and affirmations should be transmitted in a
secure manner to mitigate the possibility of theft or fraudulent correspondence. As the
confirmation and affirmation processes are critical controls, these functions should be
handled independently of the trading division.
Capacity
3.5.5 A bank should have a robust capacity management plan for its FX systems,
including trading, credit monitoring, operations, prime brokerage and settlement systems.
When assessing capacity needs, a bank should consider the sufficiency of FX systems and
operational personnel.
3.5.6 A bank should ensure its FX systems have sufficient capacity and scalability to
handle increasing and high-stress FX volumes. 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.
3.5.7 A bank should ensure its FX systems are designed appropriately for the scale of its
current and expected FX business activity. For example, a bank that offers FX prime
brokerage services should ensure that the operational arrangements supporting its prime
brokerage activities integrate seamlessly with the bank’s FX systems and do not cause
undue operational risk. Further, a bank should design its FX systems to accommodate the
potential for large trading spikes in stress situations, as appropriate. Finally, a bank’s FX
systems should be flexible enough to meet changing operational needs.
3.5.8 The capacity plan should include timely monitoring of trading volumes and capacity
utilisation of key systems. Volume monitoring is critical to a bank that engages in high-
frequency trading or has prime brokerage clients that engage in such activity, and should be
reflected in the robustness of their capacity management plan. 32 A bank should monitor
31
A trade confirmation is legal evidence of the terms of an FX transaction. A confirmation should include trade
details, settlement instructions and other relevant information to allow each counterparty to agree to the trade
terms. Trade affirmation involves acknowledging a counterparty trade notification or confirmation. Both trade
confirmation and affirmation can take many forms (eg electronic, paper or voice over a recorded phone line).
32
For more details on high-frequency trading, see High-frequency trading in the foreign exchange market, The
Markets Committee of the Bank for International Settlements, September 2011.
trading volumes in a timely manner to prevent them from reaching a critical level and assess
the potential for large FX trading spikes.
Contingency planning
3.5.9 A bank should develop and test its business resiliency and continuity plans to
ensure continued operations following a disruption. A bank should identify and address
various plausible events that could lead to disruptions in their FX-related operations and
should have appropriate systems, backup procedures and staffing plans to mitigate such
disruptions. Business continuity plans should be documented and periodically reviewed,
updated and tested.
Guideline 6: Legal risk 33
A bank should ensure that agreements and contracts are legally enforceable for each
aspect of its activities in all relevant jurisdictions.
Key considerations
1. A bank should ensure that netting and collateral agreements, including provisions
for close-out netting, are legally enforceable in all relevant jurisdictions.
2. A bank should identify when settlement finality occurs so that it understands when
key financial risks are irrevocably and unconditionally transferred as a matter of law.
Enforceability
3.6.1 Contracts, and actions taken under contracts, should be legally enforceable with a
high degree of certainty in all relevant jurisdictions even when a counterparty defaults or
becomes insolvent. 34 A bank should understand whether there is a high degree of certainty
that contracts, and actions taken under such contracts, will not be subject to a stay beyond a
de minimis period, voided or reversed. In jurisdictions where close-out netting may not be
legally enforceable, banks should ensure that they have compensating risk management
controls in place. 35
3.6.2 A bank conducting business in multiple jurisdictions should identify, measure,

monitor and control for the risks arising from conflicts of laws across 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. All opinions should be reviewed for legal
sufficiency by bank counsel, and be updated, on a regular basis.
3.6.3 Changes in law (eg new or changing legal restrictions on the use of currency) may
adversely impact a bank’s FX activities by rendering agreements and contracts
unenforceable. A bank should have procedures to monitor for, and promptly assess, changes
in law relevant to its FX agreements and contracts in jurisdictions in which it is doing
business and jurisdictions of the currencies in which it transacts.
3.6.4 If a bank’s agreements and contracts are not legally enforceable, a bank may find
itself with significant unexpected and/or un-hedged foreign exchange obligations. The
financial ramifications for a bank that has actively traded in that currency could be severe.
Settlement finality
3.6.5 A bank should obtain legal advice that addresses settlement finality with respect to
its settlement payments and deliveries. The legal advice should identify material legal
33
Legal risk is addressed as a separate guideline from operational risk in this guidance. However, under the
Basel capital framework, the definition of operational risk encompasses legal risk, which includes the legal
uncertainty or difference across jurisdictions associated with FX settlement.
34
In particular, contracts, and actions taken under contracts, include close-out netting and collateral agreements.
35
Compensating risk management controls may include, but not be limited to, reducing FX activities in the
relevant jurisdictions, imposing counterparty limits and settling transactions on a gross basis.
uncertainties regarding settlement finality so that the bank may assess when key financial
risks are transferred. The legal advice and bank’s assessment should also take into
consideration the impact of relevant bankruptcy and insolvency laws and relevant resolution
regimes. A bank needs to know with a high degree of certainty when settlement finality
occurs as a matter of law and plan for actions that may be necessary if settlement finality is
not achieved as a matter of law.
3.6.6 A bank should ensure that relevant contracts, including those with correspondent
banks (nostro agents), specify the point at which funds are received with finality, and the
point at which instructions become irrevocable and unconditional, taking into consideration
the impact of relevant bankruptcy and insolvency laws and relevant resolution regimes.
3.6.7 A bank should clearly communicate the legal status of on-us settlements so that
their customers and counterparties know when finality of settlement is achieved as a matter
of law.
Guideline 7: 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.
Key considerations
1. A bank’s analysis of its capital needs should complement the guidelines under the
current Basel capital framework and address all FX settlement-related risks,
including principal risk and replacement cost risk.
2. A bank should estimate the potential exposures associated with an FX transaction

from the point of trade execution until it confirms that the trade has settled with
finality during the reconciliation process (ie receipt of funds in account). The bank
should ensure that sufficient capital is held against these potential exposures, as
appropriate. 36
3. A bank should seek to create proper incentives or mechanisms to reduce risks

associated with FX settlement (eg by differentiating and passing on the costs to
business units based on the risk profiles of their transactions).
Analysing capital needs for FX transactions

3.7.1 A bank’s analysis of its capital needs should complement the current Basel capital
framework and address all FX settlement-related risks, including principal risk and
replacement cost risk. When incorporating FX settlement-related risks into the analysis, a
bank should refer to the Basel capital framework for capitalising risks with similar
characteristics. This should apply regardless of whether final determination of overall capital
needs is based on jurisdictional regulations, supervisor-defined factors or internal factors.
3.7.2 A bank should estimate the potential exposures associated with FX settlement-
related risks and hold sufficient capital against them, as appropriate. The analysis should
consider the impact of risk mitigants, internal controls and method of settlement on the size
and duration of the risks. This analysis should also include any impact that the choice of
settlement method may have on the bank’s assumptions regarding the netting of
replacement cost risk.
3.7.3 The estimation of potential exposures should consider the time from the point of
trade execution until confirmation that the trade has settled with finality (ie reconciled the
receipt of funds in the account). 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). 38
36
Regarding capital treatment for failed trades, see International Convergence of Capital Measurement and
Capital Standards, BCBS, June 2006.
37
Pillar I of the Basel capital framework covers a bank’s replacement cost risk exposure from trade execution
until the contracted date of settlement.
38
See Guideline 2 for appropriate methods to measure the size and duration of principal risk.
Incentives to reduce principal risk
3.7.4 A bank should create an internal incentive structure, where practicable, that is
aligned with its strategy to eliminate and reduce risks arising from FX settlement-related
exposures. The cost of such exposures should be reflected in the bank’s firm-wide strategy
(eg by risk-based capital allocation). One way to establish incentives is by differentiating the
costs or capital charges incurred by business units based on the risk profiles of their FX
transactions, and passing those costs onto them as a balance sheet charge. For example, a
business unit that executes a transaction settled via PVP would incur a lower cost for
principal risk than a business unit that executes a transaction settled by traditional gross
correspondent banking. Similarly, a business unit would typically incur a lower charge for
replacement cost risk on transactions covered under a close-out netting arrangement than on
transactions which are not covered by a close-out netting arrangement.
Annex
FX settlement-related risks and how they arise
1. In the period between FX trade execution and final settlement, a bank is exposed to
a number of different risks. The risks vary depending on the type of pre-settlement and
settlement arrangements. A bank needs to understand the risks associated with FX
transactions in order to adequately manage them.
2. Section A describes principal risk, replacement cost risk and liquidity risk. Section B
identifies and describes the presence of operational and legal risks between trade execution
and final settlement. Finally, Section C discusses the various pre-settlement and settlement
arrangements and their impact on risks.
3. For the purposes of exposition, the risks are described from the point of view of “a
bank” and a failed FX “counterparty” of that bank. Section A describes the risks relating to a
single FX trade between a bank and its counterparty. This is generalised to multiple trades in
Sections B and C.
A. Risks relating to counterparty failure to deliver the expected

currency
4. The three main risks associated with FX transactions are principal risk, replacement
cost risk and liquidity risk, which arise due to the possibility that a counterparty may fail to
settle an FX trade. This failure may be temporary (eg operational or liquidity problems of the
counterparty) or permanent (eg counterparty’s insolvency). A bank may become aware of a
potential failure at any time between trading and the completion of settlement, particularly if
the problem is due to insolvency. However, sometimes, a bank may only know that a
problem has occurred on or after settlement day when it does not receive the currency that
the counterparty was expected to deliver. Initially, a bank may not be able to identify the
cause of the failure, nor determine whether the failure is temporary or permanent.
5. A bank is exposed to principal risk, replacement cost risk and liquidity risk until it
receives the bought currency with finality.
Principal risk
6. Principal risk is the risk that a bank pays away the currency being sold, but fails to
receive the currency being bought. Principal risk can be the most serious risk because the
amount at risk can be equal to the full value of the trade. 39
7. Principal risk exists when a bank is no longer guaranteed that it can unilaterally
cancel the payment of the currency it sold (the unilateral cancellation deadline). Given that a
39
The maximum loss is the principal value of the trade. The actual loss will depend on the outcome of the
counterparty’s insolvency proceedings.
bank’s unilateral payment cancellation deadline may be one or more business days before
the settlement date, this risk can last for a significant period of time. 40
Replacement cost risk

8. Replacement cost risk is the risk that an FX counterparty will default before a trade
has settled and that the bank must replace it with a new trade and a different counterparty at
current market prices (potentially less favourable exchange rate). As such, the bank may
incur a loss relative to the original trade. Replacement cost risk exists throughout the period
between trade execution and final settlement.
Liquidity risk
9. Liquidity risk is the risk that a counterparty will not settle an obligation for full value
when due. Liquidity risk does not imply that a counterparty is insolvent since it may be able to
settle the required debit obligations at some unspecified later time.
10. Liquidity risk exists in addition to replacement cost risk. Whether a default is just a
replacement cost problem or turns into a liquidity shortage depends on whether a bank can
replace the failed trade in time to meet its obligations or, at least, to borrow the necessary
currency until it can replace the trade. In principle, liquidity risk can exist throughout the
period between trade execution and final settlement. In practice, the probability of the
problem materialising as a liquidity shortage and a replacement cost depends on many
factors, including:
• The timing of the default. The closer the default is to the settlement date, the less
time a bank has to make other arrangements.
• Whether a bank has already irrevocably paid away the currency it is selling. If so,
the bank may have fewer liquid assets available to pay for the replacement trade or
to use as collateral to borrow the currency it needs. 41
• The nature of the trade. The less liquid the currency being purchased and/or the
larger the value of the trade, the harder it may be to replace.
11. A bank may find it hard to predict the probability of a liquidity shortage, as it cannot
make a sound judgment based solely on normal market conditions. However, there is a
strong positive correlation between a counterparty default and illiquid markets (ie the default
may be the cause of the market illiquidity or an effect of it). In addition, trades that are easy
to replace in normal conditions may be impossible to replace when markets are less liquid
and experiencing stressed conditions.
B. Operational and legal risks

12. A bank may also face FX settlement-related risks caused by weaknesses in its own
operations and weaknesses in the legal enforceability of contractual terms and the governing
law applicable to its transactions. If a bank has inadequate operational capabilities or if there
are weaknesses in the legal basis for the pre-settlement and settlement arrangements, it can
40
For more information on how principal risk arises when settling FX trades, see Progress in reducing foreign
exchange settlement risk, CPSS, May 2008.
41
In this case, FX settlement-related principal risk will also exist.
face increased principal risk, replacement cost risk and liquidity risk relating to counterparty
failure.
13. Operational risk is the risk of loss due to external events or inadequate or failed
internal processes, people and systems. This definition includes legal risk and excludes
strategic and reputational risk.
14. Inadequate skills and insufficient processing capacity may increase potential
exposures. These weaknesses can cause operational delays, inaccurate confirmation and
reconciliation, or an inability to quickly correct or cancel payment instructions.
15. Legal risk occurs when a counterparty’s contractual FX obligations are non-binding,
unenforceable and subject to loss because (i) the underlying transaction documentation is
inadequate; (ii) the counterparty lacks the requisite authority or is subject to legal transaction
restrictions; (iii) the underlying transaction or contractual terms are impermissible and/or
conflict with applicable law or regulatory policies; or (iv) applicable bankruptcy or insolvency
laws limit or alter contractual remedies.
16. Legal problems may affect settlement of a foreign exchange transaction. Legal
issues may compromise the legal robustness of netting, the enforceability of unilateral
cancellation times or certainty about the finality of the receipt of currency.
C. Impact of pre-settlement and settlement arrangements on risks

17. FX settlement-related risks may be affected by the type of pre-settlement and
settlement arrangements used by a bank. Risk implications for the most common
arrangements are described below. This section focuses on the implications for the risks
related to counterparty failure described in Section A. Different pre-settlement and settlement
arrangements can also impact the operational and legal risks described in Section B – some
arrangements may be operationally more complex, require more demanding risk
management or create different legal risks. However, since these implications can vary from
bank to bank and depend on specific circumstances, they are not covered in this section.
Close-out netting
18. Legally robust and enforceable netting arrangements can be a safe and efficient
method for reducing settlement exposures. In the context of bilateral FX transactions, close-
out netting is a specific type of netting that establishes a close-out payment based on the net
present value of future cash flows between a bank and a defaulting counterparty. This
involves two counterparties entering into a formal bilateral agreement stipulating that, if there
is a defined “event of default” (eg insolvency of one of the counterparties), the unpaid
obligations covered by the netting agreement are netted. The value of those future
obligations is calculated to a net present value, usually in a single-base currency. Thus, a
series of future dated cash flows is typically reduced to one single payment due to, or from,
the closed-out counterparty.
19. Legally enforceable close-out netting reduces principal risk, replacement cost risk,
liquidity risk and operational risk for unsettled future obligations. Without close-out netting, a
bank may be required to make principal payments to a defaulted counterparty. This risk is
particularly relevant in jurisdictions without statutory provision – or with weak or ineffective
provision – for offset of obligations with a defaulted counterparty. Thus, a bank may face
gross principal risk, replacement cost risk and liquidity risk on transactions not covered by a
legally enforceable netting agreement.
Bilateral obligation netting
20. Under bilateral obligation netting, FX transactions between two counterparties due
to settle on a certain date are netted to produce a single obligation to pay in each currency
on that date (ie each counterparty has an obligation to pay a single amount in those
currencies in which it is a bilateral net seller). Those net amounts are likely to be smaller than
the original gross amounts, reducing principal and liquidity risks. Obligation netting can take
different forms (eg netting by novation) and may vary by jurisdiction. Their effectiveness
depends on the legal soundness of the contractual terms.
Collateral arrangements
21. If netting is accompanied by a collateral arrangement, replacement cost risk can be
reduced further. A collateral arrangement is where the counterparty with the negative net
position provides financial assets to the other counterparty in order to secure that obligation.
Collateral could be taken to cover only price movements that have already occurred.
However, in this case, if there is a counterparty default, a bank is still exposed to further
movements that may occur between the time collateral was last taken and the time that the
bank succeeds in replacing the trade (potential future exposure). Further protection can be
achieved if collateral is also taken to cover the potential future exposure. Since the actual
size of this exposure cannot be determined until after the event, the degree of additional
protection depends on the assumptions made when calculating the collateral amount. 42 Note
that such collateral arrangements are typically not used to provide protection against liquidity
or principal risk.
Settlement via traditional correspondent banking

22. Under this settlement method, each counterparty to an FX trade transfers to the
other counterparty the currency it is selling, typically using their correspondent banks for the
currencies concerned. Once a payment instruction is irrevocable, the full amount being
transferred is subject to principal risk, and some portion may be subject to replacement cost
risk and liquidity risk.
On-us settlement
23. On-us settlement is where both legs of an FX transaction are settled across the
books of a single institution. On-us settlement can occur either where one counterparty to a
transaction provides accounts in both currencies to the other counterparty, or where one
institution provides accounts to both counterparties to an FX transaction in both currencies. 43
The account provider debits one of its customer’s accounts and credits the other, while
making opposite debits and credits to its own account. Those credits can be made
simultaneously (via PVP) or at different times, in which case one counterparty may be
exposed to principal risk from the other counterparty. Irrespective of whether principal risk
exists, normal correspondent credit risks are also likely to exist.
42
As with any collateral arrangement, there is a risk that the value of the collateral may decline. Thus, the
degree of protection against both current and potential future exposure also depends on the type of collateral
and the haircut applied.
43
For example, a bank provides accounts to two of its customers, which have traded with each other.
Payment-versus-payment settlement
24. Payment-versus-payment (PVP) settlement is a mechanism that ensures the final
transfer of a payment in one currency if, and only if, a final transfer of a payment in another
currency occurs, thereby removing principal risk. There are various forms of PVP settlement
arrangements, including the type offered by CLS Bank International (CLS Bank). 44 Another
form consists of a link between payment systems in the two currencies, where a payment is
made in one system if, and only if, payment is made in the other system. PVP arrangements
do not guarantee settlement. In a basic PVP arrangement, a trade will settle only if a bank
and its counterparty pay in the correct amount. If the counterparty fails to pay in, a bank will
receive back the currency it was selling, thus providing protection against principal risk.
However, it will still be short on the currency that it was buying and face liquidity risk equal to
the full amount of that currency, as well as the replacement cost risk on that amount.
Central clearing
25. A central counterparty (CCP) is an entity that interposes itself between
counterparties to trades in a financial market, thus, becoming the buyer to every seller and
the seller to every buyer. In this way, a form of multilateral obligation netting is achieved
among the original counterparties. Currently, CCPs for FX trades involving an exchange of
payments at settlement are rare, but they may become more widespread in the future.
Indirect participation in settlement or CCP arrangements

26. A bank may choose to be an indirect participant of a settlement or CCP
arrangement (ie a customer of a direct participant). In this case, the FX settlement-related
risks a bank faces will depend, in part, on the exact terms of the service provided by the
direct participant. Thus, the risks associated with indirect participation may not be the same
as those associated with direct participation.
44
For a description of the CLS system, see Progress in reducing foreign exchange settlement risk, CPSS,
May 2008, Annex 4.
Glossary
Bilateral netting A general term describing an arrangement to offset the

obligations between two parties to a single bilateral
obligation. The obligations covered by the arrangement may
arise from financial contracts, transfers or both.
Bilateral obligation netting A form of netting where two counterparties agree (via a
legally-enforceable netting agreement) to settle transactions
by making or receiving a single payment in each of the
currencies (ie each counterparty has an obligation to pay a
single amount in those currencies in which it is a bilateral
net seller). This reduces the value at risk by replacing
multiple gross obligations (that would, otherwise, be settled
on a trade-by-trade basis) with one netted obligation.
Central counterparty (CCP) An entity that interposes itself between counterparties to
trades in a financial market, becoming the buyer to every
seller and the seller to every buyer.
Close-out netting A form of netting which occurs following some predefined
events, such as default. Close-out netting establishes a
close-out payment based on the net present value of future
cash flows due between a bank and a defaulting
counterparty. Close-out netting is intended to reduce
exposures on open contracts with a defaulting counterparty.
(Also referred to as “default netting”, “open contract netting”
or “replacement contract netting”).
CLS Bank International Owned by the foreign exchange community, CLS Bank
(CLS Bank) operates a multi-currency PVP cash settlement system to
mitigate settlement risk in the foreign exchange market.
Confirmation and The process in which the terms of a trade are verified either
affirmation by market participants or by a central entity. A trade
confirmation is legal evidence of the terms of an FX
transaction. Trade affirmation involves acknowledging a
counterparty trade notification or confirmation. Both trade
confirmation and affirmation can take many forms (eg
electronic, paper or voice over a recorded phone line).
Contingency planning The development of practical and credible plans to promote
resiliency during periods of severe financial distress and to
facilitate a rapid resolution. The plans should ensure access
to relevant information in a crisis and help evaluate
resolution options.
Correspondent banking An arrangement in which one bank (correspondent) holds
deposits owned by other banks (respondents) and provides
payment and other services to those respondent banks.
Such arrangements may also be known as “agency
relationships” in some domestic contexts. In international
banking, balances held for a foreign respondent bank may
be used to settle FX transactions. Reciprocal correspondent
banking relationships may involve the use of nostro and
vostro accounts to settle foreign exchange transactions.
Credit support annex (ISDA A legal document that regulates credit support (collateral)
CSA) for derivative transactions. It is one of the four parts that
make up an ISDA master agreement, but is not mandatory.
A CSA defines the terms or rules under which collateral is
posted or transferred between swap counterparties to
mitigate the credit risk arising from “in the money” derivative
positions. Terms include thresholds, minimum transfer
amounts, eligible securities and currencies, haircuts
applicable to eligible securities and rules for settling or
resolving disputes over valuation of derivative positions.
Currency swap An agreement between two parties to exchange aspects
(namely the principal and/or interest payments) of a loan in
one currency for equivalent aspects of a loan in another
currency at some point in the future according to a specified
formula. Currency swaps are over-the-counter derivatives
and are closely related to interest rate swaps. However,
unlike interest rate swaps, currency swaps generally involve
the exchange of the principal. (Also known as a “cross-
currency swap”).
Derivatives Financial contracts whose values depend on the value of
one or more underlying reference assets, rates, currencies
or indices.
Enforceable A legal document, agreement, right or obligation is
enforceable if the party obligated can be forced or ordered
to comply through a legal process.
Fail A failure to settle a transaction on the contractual settlement
date, usually due to technical or temporary difficulties. Fails
typically arise from operational problems, while “defaults”
arise from credit or solvency problems. (Also known as a
“failed transaction”).
Financial market A multilateral system among participating institutions,
infrastructure (FMI) including the operator of the system, used for purposes of
clearing, settling or recording payments, securities,
derivatives or other financial transactions.
FX forward A contract between two parties that agree to buy or sell an
amount of currency against a second currency at a specified
future date (more than two business days later) and at an
agreed-upon rate on the date of the contract.
FX spot The purchase of one currency for another, with immediate
delivery according to local market convention (usually two
business days) at an agreed-upon price on trade date.
FX swap A contract between two parties that simultaneously agree to
buy or sell an amount of currency against a second currency
at an agreed-upon rate; and to resell or repurchase the
same currency at a later date with the same counterparty,
also at an agreed-upon rate.
Governance The set of relationships among a bank’s board of directors,
management, shareholders and other interested parties or
stakeholders. Governance also provides the structure for
setting company objectives, the means of attaining those
objectives and the framework for monitoring performance.
In/out swap (with regard to An in/out swap comprises two equal and opposite FX
CLS Bank only) transactions that are agreed-upon as an intraday swap
between two CLS Bank settlement members. One of the
two FX transactions is settled through CLS Bank to reduce
each member’s net position in the two currencies. The other
transaction is settled outside of CLS Bank. The combined
effect of these two FX transactions reduces funding
requirements of the two members during the CLS Bank
settlement session, but leaves the institutions’ overall FX
positions unchanged.
Initial margin Collateral that is collected to cover potential changes in the
value of each participant’s position (also known as “potential
future exposure”) over the appropriate close-out period in
the event the participant defaults.
Legal risk The risk of an unexpected application of a law or regulation,
usually resulting in a loss.
Liquidity risk The risk that a bank is unable to make payments due to a
shortage of liquidity arising from a counterparty (or
participant in a settlement system) not settling an obligation
for full value when due. Liquidity risk does not imply that a
counterparty or participant is insolvent since it may be able
to settle the required debit obligations at some unspecified
later time.
Margin call A demand for additional funds or collateral (following the
marked-to-market of a margined transaction) if the market
value of the underlying collateral falls below margin
requirements.
Master netting agreement A master netting agreement (eg ISDA or IFEMA) sets forth
the standard terms and conditions applicable to all, or a
defined subset of, transactions that the parties may enter
into from time to time. Includes the terms and conditions for
close-out and obligation netting.
Multilateral netting Netting on a multilateral basis is the offsetting of obligations
between or among multiple participants to a net position per
participant.
Non-deliverable forwards An outright forward or futures contract in which
(NDFs) counterparties settle the difference between the contracted
NDF price or rate and the prevailing spot price or rate on an
agreed notional amount.
Nostro account A foreign currency-denominated account (usually at a
foreign bank) where a domestic bank keeps reserves to
maintain its balance in that currency and to make and
receive payments.
On-us settlement On-us settlement is where both legs of an FX transaction
are settled across the books of a single institution. On-us
settlement can occur either where one counterparty to a
transaction provides accounts in both currencies to the other
counterparty, or where one institution provides accounts to
both counterparties to an FX transaction in both
currencies. 45 The account provider debits one of its
customer’s accounts and credits the other, while making
opposite debits and credits to its own account.
Operational risk The risk of loss resulting from inadequate or failed internal
processes, people and systems, or from external events.
This definition includes legal risk and excludes strategic and
reputational risk.
Payment-versus-payment A settlement mechanism that ensures the final transfer of a
(PVP) settlement payment in one currency if, and only if, a final transfer of a
payment in another currency occurs.
Potential future exposure The most common measure of forward-looking exposure. It
is the maximum expected exposure over a specified interval
of time calculated at some level of confidence. Potential
future exposure is the additional exposure that a
counterparty might potentially assume during the life of a
contract, or set of contracts, beyond the current replacement
cost. It is calculated by evaluating existing trades executed
against possible market prices in the future. Both initial
margin and variation margin mitigate this future exposure.
Variation margin mitigates actual price volatility so that the
price protection provided by initial margin is maintained.
Prime brokerage A service that enables a bank’s customer to conduct
transactions in the name of the bank (the prime broker). The
prime broker sets up an arrangement that permits the
customer to trade directly with dealers in the name of the
prime broker. These dealers recognise the prime broker (not
the customer) as the counterparty in these trades.
Principal risk The risk of outright loss of the full value of a transaction
resulting from the counterparty’s failure to settle. This can
arise from paying away the currency being sold, but failing
to receive the currency being bought. (Also referred to as
“Herstatt Risk”).
45
For example, a bank provides accounts to two of its customers, which have traded with each other.
Principal risk duration The length of time that a bank might be exposed to principal
risk from an FX transaction. This length of time extends from
the unilateral payment cancellation deadline to the time a
bank receives, with finality, the purchased currency. (There
may also be additional time needed for a bank to confirm
receipt of the expected settlement payment and to reconcile
the settlement payment against its outstanding
transactions.) Depending on the internal practices,
procedures or any legal agreements of a bank and its
correspondent bank, the duration of a bank’s principal risk
may begin as soon as the bank submits its payment order
for a sold currency.
Real-time gross settlement The continuous (real-time) settlement of funds or securities
(RTGS) on an order-by-order basis (without netting).
Replacement cost risk The risk of loss due to unsettled transactions with a
counterparty. The resulting exposure is the cost of replacing
the original transaction at current market prices.
Risk appetite A high-level determination of how much risk a bank is willing
to accept considering risk/return attributes. Risk appetite is a
forward-looking view of risk acceptance.
Risk tolerance The formal designation of the level of risk the bank is willing
to accept in pursuit of business objectives. The board of
directors sets the bank’s risk tolerance and risk capital.
Settlement finality The irrevocable and unconditional transfer of an asset or
financial instrument, or the discharge of an obligation by the
FMI or its participants in accordance with the terms of the
underlying contract. Final settlement is a legally defined
moment.
Straight-through processing Automated processing that allows data to be entered into
(STP) technical systems once and is then used for all subsequent
processing of transactions.
Stress test An estimation of credit and liquidity exposures that would
result from extreme price and implied volatility scenarios.
Unilateral payment The point in time after which a bank is no longer guaranteed
cancellation deadline that it can recall, rescind or cancel (with certainty) a
previously submitted payment instruction. This deadline
varies depending on the currency pair being settled,
correspondent payment system practices, and operational,
service and legal arrangements.
Variation margin Variation margin is an amount of collateral posted to cover
exposures resulting from actual changes in market prices.
(Also known as “mark-to-market margin”).
Bibliography
BCBS, Basel III: International framework for liquidity risk measurement, standards and
monitoring, December 2010.
BCBS, Core principles for effective banking supervision, September 2012.
BCBS, International Convergence of Capital Measurement and Capital Standards,
June 2006.
BCBS, Principles for enhancing corporate governance, October 2010.
BCBS, Principles for sound liquidity risk management and supervision, September 2008.
BCBS, Principles for the sound management of operational risk, June 2011.
BCBS, Principles for sound stress testing practices and supervision, May 2009.
BCBS, Supervisory guidance for managing risk associated with the settlement of foreign
exchange transactions, 2000.
BCBS/Joint Forum, High-level principles for business continuity, August 2006.
BIS, High-frequency trading in the foreign exchange market, September 2011.
CPSS/IOSCO, Principles for financial market infrastructures, assessment methodology and
disclosure framework, April 2012.
CPSS, Progress in reducing foreign exchange settlement risk, May 2008.
CPSS, Reducing foreign exchange settlement risk: a progress report, July 1998.
CPSS, Settlement risk in foreign exchange transactions, March 1996.
ESMA, Guidelines on systems and controls in an automated trading environment for trading
platforms, investment firms and competent authorities, December 2011.
FSR, The CLS system: reducing settlement risk in foreign exchange transactions, November
2002.
IOSCO, Regulatory issues raised by the impact of technological changes on market integrity
and efficiency, consultation ended August 2011.
Foreign Exchange Committee, Management of operational risk in foreign exchange, revised
November 2010.
Members of the Joint BCBS-CPSS Working Group
on Foreign Exchange Settlement Risk
Chair: Ms Jeanmarie Davis, Federal Reserve Bank of New York
Australia Reserve Bank of Australia Mr Greg Chugg

Belgium National Bank of Belgium Mr Benoît Bourtembourg
Canada Bank of Canada Mr Paul Miller
Bank of Canada Mr Peter Youngman
France Banque de France Mr Sébastien Frappa
Germany Deutsche Bundesbank Ms Sylvia Tyroler
Federal Financial Supervisory Authority Mr Felix Kallmeyer
Hong Kong SAR Hong Kong Monetary Authority Mr Kwok hung Lee
Italy Bank of Italy Ms Angela Caporrini
Japan Bank of Japan Mr Takuto Ninomiya
Korea Bank of Korea Mr Kwangsok Choi
Netherlands Netherlands Bank Mr Lars Groenhuijse
Russia Central Bank of the Russian Federation Mr Alexey Aspisov
Saudi Arabia Saudi Arabian Monetary Agency Mr Messad Abdullah AlAbdaly
Singapore Monetary Authority of Singapore Ms E-Chin Huang
Spain Bank of Spain Mr Vicente Cabañas
Bank of Spain Mr Carlos Conesa
Switzerland Swiss Financial Market Supervisory Authority Mr Patrick Winistoerfer
United Kingdom Bank of England Mr Jack Garrett-Jones
Financial Services Authority Mr Colin Atkinson
United States Federal Reserve Board Mr Mark Magro
Federal Reserve Bank of New York Mr Lawrence Sweet
Federal Reserve Bank of New York Ms Lisa Joniaux
Office of the Comptroller of the Currency Ms Caroline Smith
European Central Bank Mr Giampiero Carla
European Central Bank Mr Marco Galbiati
European Central Bank Mr Johannes Lindner
CPSS Secretariat Ms Emma Bäcke
CPSS Secretariat Mr Robert Lindley
CPSS Secretariat Mr Tomohiro Usui
BCBS Secretariat Mr Kwang Ho Chon

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Basel Committee

Supervisory guidance for

ISBN 92-9131-915-5 (print)

Overview of Guidelines .......................................................................................................... 1

Guideline 2: Principal risk

Guideline 3: Replacement cost risk

Guideline 4: Liquidity risk

Guideline 5: Operational risk

Guideline 6: Legal risk

Guideline 7: Capital for FX transactions

BCBS Basel Committee on Banking Supervision

2.8 In cases where supervisors determine that a bank’s management of FX settlement-

2.10 Supervisors should assess whether a bank is appropriately incorporating principal

2.11 To fully address FX settlement-related risks, banks’ incentives, business practices

2. A bank should have a comprehensive risk management framework to manage FX

Strong governance of FX settlement-related risks

Comprehensive risk management framework

Management information systems and key risk indicators

Internal audit and compliance program

Selection of a correspondent bank

Dependence on other institutions

Eliminating principal risk using PVP settlement

Controlling remaining principal risk

Measuring expected principal risk

(a) Unilateral payment cancellation deadlines

(b) Reconciling incoming payments

(c) Use of approximation techniques

Reducing the size of remaining principal risk

Identifying, measuring, monitoring and controlling exposures

Setting and using limits

Duration of replacement cost risk and the timing of settlement

Netting and collateral arrangements

3.3.8 Non-cash collateral assets should be highly liquid in order to be liquidated in a

Liquidity risk management framework

Identify and manage liquidity needs

Liquidity risks associated with an FMI

Liquidity risks associated with the use of a correspondent bank

Operational risk management framework

Straight-through processing (STP)

Trade confirmation and affirmation31

3.6.2 A bank conducting business in multiple jurisdictions should identify, measure,

2. A bank should estimate the potential exposures associated with an FX transaction

3. A bank should seek to create proper incentives or mechanisms to reduce risks

Analysing capital needs for FX transactions

FX settlement-related risks and how they arise

A. Risks relating to counterparty failure to deliver the expected

Replacement cost risk

B. Operational and legal risks

C. Impact of pre-settlement and settlement arrangements on risks

Settlement via traditional correspondent banking

Indirect participation in settlement or CCP arrangements

Bilateral netting A general term describing an arrangement to offset the

Chair: Ms Jeanmarie Davis, Federal Reserve Bank of New York

Australia Reserve Bank of Australia Mr Greg Chugg

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