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FXC Updates ‘Managing Op Risk in Foreign Exchange’ Best Practice Document

The New York-based Foreign Exchange Committee has released an updated version of its best-practice document Management of Operational Risk in Foreign Exchange, which encourages all significant players to use the settlement services provided by CLS Bank.

New language has been included in the document to reflect the FXC’s commitment to the importance of utilising payment-versus-payment services such as Continuous Linked Settlement (CLS) to further mitigate settlement risk.

The FXC says it strongly believes that increased use of CLS in concert with a broader use of credit risk mitigation strategies such as credit support annexes benefits the global foreign exchange market.

“Together, these tools provide significant risk mitigation while preserving the flexibility, accessibility, and efficiency of this highly important and interconnected market,” says Jeff Feig, chair of the FXC.

In a November 2009 paper, the Foreign Exchange Committee observed that the availability of CLS was a key contributor to the robust functioning of the FX market during the recent period of financial market disruption. Accordingly, Best Practice number 34 in the document has now been amended as follows:

“Understand the settlement process and settlement exposure and use settlement services wherever possible to reduce settlement risk within the market. Market participants should measure and monitor settlement risk exposures. All senior managers should obtain a high-level understanding of the settlement process as well as of the tools that exist to better manage settlement risk. Additionally, both credit and risk managers (those managing position risk and credit risk) should be cognisant of the impact their internal procedures have on settlement exposure.

“Settlement risk may be reduced if those involved in the process better understand the ramifications of its possible failure. Senior management, sales and trading, operations, risk management, and credit management should understand the process and be aware of the timing of the following key events in the process: when payment instructions are recorded, when they become irrevocable, and when confirmation of counterparty payment is received with finality. Knowledge of these items allows the duration and amount of FX settlement exposure to be better quantified.

“Both credit and risk managers should develop accurate methods to quantify settlement risk. A bank’s actual exposure when settling an FX trade equals the full amount of the currency purchased, and lasts from the time a payment instruction for the currency sold can no longer be cancelled unilaterally until the currency purchased is received with finality.

“Market participants should adequately utilise settlement services that reduce their exposures to settlement risk whenever possible, for example, through the use of payment-versus-payment services, such as those offered by CLS, for the settlement of eligible foreign exchange transactions. Counterparties currently unable to use such services should be encouraged to consider ways to use them.”

In a separate development, the FXC has provided an overview of credit risk in foreign exchange, including a detailed discussion of the use of credit support annexes in the marketplace in its paper on Tools for Mitigating Credit Risk in Foreign Exchange Transactions. The paper also introduces language on prudent management of credit risk to the Committee’s best-practice documents: Guidelines for Foreign Exchange Trading Activities and Management of Operational Risk in Foreign Exchange.

To view the paper, go to: http://www.ny.frb.org/FXC/2010/Nov22Letter.pdf

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