Risk associated with the settlement of foreign exchange transactions is a topic of concern to central bank counsel and is currently the focus of international attention. This chapter draws directly from the work of the Committee on Payment and Settlement Systems of the Central Banks of the Group of Ten Countries (the Committee), as most recently reflected in the report published by the Bank for International Settlements (BIS), entitled Settlement Risk in Foreign Exchange Transactions (the Report).2 In essence, the Report analyzes the existing arrangements for settling foreign exchange trades and offers practical approaches for reducing foreign exchange settlement risk. The approaches are grounded in the belief that individual banks and industry groups, with cooperation (and a little friendly encouragement) from central banks, can make important progress in reducing this risk.


Risk associated with the settlement of foreign exchange transactions is a topic of concern to central bank counsel and is currently the focus of international attention. This chapter draws directly from the work of the Committee on Payment and Settlement Systems of the Central Banks of the Group of Ten Countries (the Committee), as most recently reflected in the report published by the Bank for International Settlements (BIS), entitled Settlement Risk in Foreign Exchange Transactions (the Report).2 In essence, the Report analyzes the existing arrangements for settling foreign exchange trades and offers practical approaches for reducing foreign exchange settlement risk. The approaches are grounded in the belief that individual banks and industry groups, with cooperation (and a little friendly encouragement) from central banks, can make important progress in reducing this risk.

This chapter focuses on the Report and then identifies legal issues raised by the Committee’s specific findings and recommendations. While the Report itself does not address legal issues, successful resolution of some of the legal issues raised herein will be essential to the implementation of the Report’s recommendations. While enormous progress has been made to increase legal certainty in recent years in areas such as netting, other issues, such as those related to payment finality and cross-border insolvency, remain largely unresolved. Coordinated international efforts to address some of these issues are currently under way and are a particular focus of national bank supervisors and central banks. Also addressed by this chapter are some challenges faced by private sector groups attempting to establish multicurrency foreign exchange clearing mechanisms.

The Report is based on the work of the Steering Group, which the Committee formed in June 1994 to build upon its past work and to develop a strategy for reducing foreign exchange settlement risk. The Report was released in March 1996 and is one of a series of efforts undertaken in the past twenty or so years to deal with issues raised by the globalization of financial markets. Payments issues in particular have come into sharp focus in recent years, given the growth of cross-border financial activity and the worldwide interrelationship of payment and settlement systems. Today, markets are so interconnected that trouble originating in any market can spread quickly around the world. This is a concern to central bankers responsible for overseeing the smooth functioning of payment systems worldwide, as well as to managers of financial institutions. Settlement risk in the foreign exchange market is especially troublesome because its effects can be felt across national borders and can impact the financial system globally.

Foreign exchange trading has grown dramatically in the past 20 years. The operational capacity of banks to settle trades has greatly improved, but current settlement practices (as identified by a survey conducted by the Committee, which is addressed in some detail later) generally expose each trading bank to the risk of incomplete settlement. Given the estimated $1¼ trillion of foreign exchange trades arranged daily, the resulting large exposures raise significant concerns for individual banks and the international financial system as a whole. These concerns include the effects on the safety and soundness of banks, the adequacy of market liquidity, market efficiency, and overall financial stability.

As the Committee concluded, close cooperation among central banks, and between central banks and the private sector, is absolutely critical in addressing systemic risks arising from the expansion of cross-border payments and clearance and settlement systems. Unilateral action by a central bank would likely not accomplish very much in this area.

Settlement Risk Distinguished from Other Risks

Settlement of a foreign exchange trade requires the payment of one currency and the receipt of another. The principal risk in settlement of such trade is that one party would pay out the currency it sold but not receive the currency it bought. This is called foreign exchange or cross-currency settlement risk.

The Steering Group points out in the Report that foreign exchange or cross-currency settlement risk has a credit risk dimension, that is, whenever a party cannot condition its payment of the currency it sold upon final receipt of the currency it bought, it faces the possibility of losing the full principal value involved in the transaction. This may be viewed as a credit exposure to the counterparty equal to the full principal amount of the currency purchased.

This could, of course, also lead to liquidity risk. If a party does not receive the currency it purchased when due, it would need to finance the shortfall until its counterparty delivers the currency it owes.

Finally, the Steering Group identifies other risks raised by foreign exchange trading, such as market risk, which is the risk that the market will move against the nondefaulting party; replacement risk, or the risk of having to replace at current exchange rates an unsettled yet profitable foreign exchange transaction with a failed counterparty; and operational risk, the risk of incurring interest charges or other penalties for misdirecting or otherwise failing to make foreign exchange settlement payments on time because of an error or technical failure.

The Herstatt Episode

Foreign exchange settlement risk first came into sharp focus in 1974 with the collapse of Bankhaus Herstatt, a small bank in Cologne, Germany active in the foreign exchange market. Herstatt was closed by its banking supervisor at the end of the German business day. This was 10:30 a.m. New York time. Prior to the announcement of the closure, several of Herstatt’s counterparties had irrevocably paid deutsche mark to Herstatt on that day anticipating that they would receive U.S. dollars later the same day in New York. Upon its closure, Herstatt’s New York correspondent bank suspended outgoing U.S. dollar payments from Herstatt’s account. This action left its counterparties exposed to credit and liquidity risk up to the full value of deutsche mark deliveries made. Moreover, banks that had entered into forward trades with Herstatt not yet due for settlement lost money in replacing the contracts in the market, and others had deposits with Herstatt. The Herstatt incident served to focus both public and private sector awareness on the problems created by settling different legs of the same transaction in different markets and time zones, leading unavoidably to counterparty settlement risk.

Group of Ten Initiatives to Address Concerns

In response to the Herstatt episode, the Group of Ten central banks began working together on supervisory issues, including foreign exchange market risk and the need for an international early warning system. Initially, this work was often associated with efforts to understand the benefits and risks of netting. The earlier work of the Group of Experts on Payment Systems resulted in the 1989 Report on Netting Schemes, also known as the “Angell Report.”3 This report analyzed the credit and liquidity risks experienced by participants in bilateral and multilateral netting arrangements for both interbank payment orders and forward-value contractual commitments, such as foreign exchange contracts. The Angell Report also identified a number of broader policy issues and expressed concern over the difficulty of providing effective oversight of cross-border netting systems. The Angell Report developed an agreed language and understanding of netting, an important first step in dealing with a common technique in payments arrangements.

A committee headed by Alexandre Lamfalussy, general manager of the BIS, was set up by the Group of Ten governors to deal with the broader policy issues and concerns raised in the Angell Report. As a result of the committee’s work, the BIS published a study on interbank netting schemes in 1990 known as the “Lamfalussy Report.”4 This report recommended a set of minimum standards for the operation of cross-border and multicurrency netting schemes, and principles for cooperative oversight by central banks.5 The minimum standards are designed to ensure that participants and service providers produce arrangements that obtain the benefits of netting without introducing systemic risks. The Lamfalussy Report was a particularly important step in central bank cooperation for coping with payments system risks.

Because the Lamfalussy Report did not directly attack the issue of settlement risk in foreign exchange trades, the Committee on Payment and Settlement Systems published in 1993 a report entitled Central Bank Payment and Settlement Services with Respect to Cross-Border and Multi-Currency Transactions, commonly referred to as the “Noël Report.”6 This report was analytical in nature and outlined the thinking of the Group of Ten central banks on ways to address settlement risks. The analysis was designed to advance the current understanding of the issues involved in reducing or eliminating foreign exchange settlement risk and deliberately did not produce recommendations. Instead, it sought only to evoke industry reaction.

As mentioned, the Committee formed the Steering Group to build upon this past work and to develop a strategy for reducing foreign exchange settlement risk. This work resulted in the Report.

The Report on Settlement Risk in Foreign Exchange Transactions

This part focuses on specific aspects of the Report’s findings and recommendations. First, the methodology identified by the Steering Group for measuring foreign exchange settlement exposure is outlined. Next, the key findings of a survey conducted by the Steering Group of 80 banks in the Group of Ten countries on current market practices for managing settlement risks are reviewed. In particular, the current efforts of individual banks to control risk and improve settlement practices, and those of banks collectively to develop risk-reducing multicurrency services, are addressed. Then, a brief description of the three-step strategy proposed by the governors of the Group of Ten central banks for reducing foreign exchange settlement risk is set forth. Finally, the legal issues raised by the Report are analyzed.

Methodology for Measuring Foreign Exchange Settlement Exposure

The following is an overview of the methodology used by the Steering Group for measuring foreign exchange settlement exposure. The Group began by defining the nature and scope of the exposure. The definition is as follows:

A bank’s actual exposure—the amount at risk—when settling a foreign exchange 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 time the currency purchased is received with finality.7

The Report points out that for a bank to measure current and future foreign exchange settlement exposures in this way, it would need to recognize the changing status of each of its trades during the settlement process. In other words, a bank would need to be able to distinguish and track when its payment instructions can no longer be cancelled unilaterally and when it has received currency with finality. In order to accomplish this, a bank needs to understand the legal status of the trade. The Report classifies a trade’s status according to five broad categories:

  • Status R (revocable). Status R, or revocable, relates to when a “bank’s payment instruction for the sold currency either has not been issued or may be unilaterally cancelled without the consent of the bank’s counterparty or any other intermediary. The bank faces no current settlement exposure for this trade.”8

  • Status I (irrevocable). Status I, or irrevocable, is when a “bank’s payment instruction for the sold currency can no longer be cancelled unilaterally either because it has been finally processed by the relevant payments system or because some other factor (e.g., internal procedures, correspondent banking arrangements, local payments system rules, laws) makes cancellation dependent upon the consent of the counterparty or another intermediary; the final receipt of the bought currency is not yet due. In this case, the bought amount is clearly at risk.”9

  • Status U (uncertain). Status U means the status is uncertain. “The bank’s payment instruction for the sold currency can no longer be cancelled unilaterally; receipt of the bought currency is due, but the bank does not yet know whether it has received these funds with finality. In normal circumstances, the bank expects to have received the funds on time. However, since it is possible that the bought currency was not received when due (e.g., owing to an error or to a technical or financial failure of the counterparty or some other intermediary), the bought amount might, in fact, still be at risk.”10

  • Status F (fail). Payment is in a Status F, or a fail, when the “bank has established that it did not receive the bought currency from its counterparty. In this case the bought amount is overdue and remains clearly at risk.”11

  • Status S (settled). Finally, a trade is considered settled, or is in Status S, when the “bank knows that it has received the bought currency with finality. From a settlement risk perspective, … the bought amount is no longer at risk.”12

The drafters of the Report concluded that once a bank determines the status of its trades, it can easily calculate its foreign exchange settlement exposure. Banks that always identify their final and failed receipts of bought currencies as soon as they are due can determine their exposures exactly. For these banks, current exposure equals the sum of their Status I and F trades, that is, those trades for which the bank has issued an irrevocable payment instruction for the sold currency (but has not received the bought currency) and those trades that have failed. In contrast, banks that do not immediately identify their final and failed receipts cannot pinpoint the exact size of their foreign exchange settlement exposures.

Faced with this uncertainty, a bank should be aware of both its minimum and maximum potential foreign exchange settlement exposure. The Report provides general guidelines for a bank to follow to measure its minimum and maximum potential exposure on the basis of the current status of its unsettled trades. Minimum exposure would be equal to the sum of Status I and F trades, and maximum exposure would be those trades plus any Status U trades.13

Findings of the Report Based on Market Survey

The drafters of the Report conducted a survey of approximately 80 banks in the Group of Ten countries to understand how market participants currently measure and manage settlement risk. The findings of the survey can be summarized as follows:

Finding: Foreign exchange settlement exposure is not just an intraday phenomenon: current foreign exchange settlement practices create interbank exposures that can last, at a minimum, one to two business days, and it can take a further one to two business days for banks to know with certainty that they received the currency they bought.14

Explanation: The Report indicates that for most banks surveyed, and in every Group of Ten country, the minimum foreign exchange settlement exposure of an individual spot or forward trade currently lasts for between one and two business days. In addition, it notes that it can take an additional one to two business days for many banks to establish whether they have received the bought currency on time. Furthermore,

the often lengthy duration of foreign exchange settlement exposure reflects the fact that current practices for handling payments and receipts were designed more for operational efficiency … than for controlling settlement exposures … Once they begin, certain automated procedures can make it difficult, if not impossible, for a bank or its correspondent to cancel unexecuted payment instructions even before settlement day. This can increase the duration of foreign exchange settlement exposures by creating overly restrictive unilateral payment cancellation deadlines.15

Finding: Given current practices, a bank’s maximum foreign exchange settlement exposure could equal, or even surpass, the amount receivable for three days’ worth of trades, so that at any point in time—including weekends and public holidays—the amount at risk to even a single counterparty could exceed a bank’s capital.16

Explanation: The survey also found:

The size of a bank’s total foreign exchange settlement exposure depends directly on the duration of the settlement exposure of each of its trades. For instance, if a bank’s minimum settlement exposure for a single foreign exchange trade lasts 48 hours, at least two days’ worth of trades would always be at risk. In addition, if it takes, for example, another 24 hours to verify the final receipt of each purchased currency, a further day’s worth of trades might still be at risk.

No comprehensive statistics are yet available on the banks’ actual levels of foreign exchange settlement exposure, partly reflecting the fact that most banks currently do not measure them properly, if at all. Nevertheless, several banks indicated that their current exposures can reach very high amounts. For instance, some banks said that they routinely settle foreign exchange trades worth well over US$1 billion with a single counterparty on a single day. If current practices can transform this level of activity into an actual foreign exchange settlement exposure that is two to three times this amount, bilateral foreign exchange settlement exposures could be large in relation to a bank’s capital and could far exceed the short-term credit exposure a bank incurs in other activities with the same counterparty.17

Finding: Individual banks could, if they so choose, significantly reduce their own exposures and systemic risk more broadly by improving their back office payments processing, correspondent banking arrangements, obligation-netting capabilities, and risk management controls.18


The survey indicated that a bank’s foreign exchange settlement practices can greatly influence the size of its exposures. One way a bank can lower its exposure is by changing the timing of its unilateral payment cancellation deadlines and of its identification of final and failed receipts.19

This could require changes to a bank’s own settlement practices and possibly correspondent arrangements. Another way to lower exposures “is by legally binding netting of the daily settlement obligations arising out of a bank’s foreign exchange trades rather than settling each trade individually.”20 This reduces the amount at risk by lowering the number and size of payments needed to settle on a trade-by-trade basis.

Finding: Well-designed multicurrency services, such as multicurrency settlement mechanisms and bilateral and multilateral obligation netting arrangements, could greatly enhance the efforts of individual banks to reduce their foreign exchange settlement exposures.21

Some major banks are concerned about the sizable foreign exchange settlement risks they face and are actively pursuing ways to improve their own settlement practices and to collectively develop risk-reducing multicurrency services.

Nevertheless, despite their considerable capacity to reduce foreign exchange settlement risk through individual and collective action, many banks remain skeptical about devoting significant resources to such efforts.


Risk awareness. The survey revealed:

Although most banks are familiar with the concept of foreign exchange settlement risk, not all banks have a single officer who understands the entire settlement process and the risks it entails, so that meetings with some banks for the purpose of the market survey required the presence of representatives from several different departments in order to cover all aspects of the subject. Moreover, some market participants indicated that the senior executives of their banks had never been fully briefed on the foreign exchange settlement process and the associated risks.22

Risk measurement. In addition, the survey revealed:

Overall, many banks currently underestimate the duration and size of their foreign exchange settlement exposure by treating it as an intraday amount no larger than a single day’s expected receipts. Only a few banks treat irrevocable payment instructions issued prior to settlement day as part of their foreign exchange settlement exposure. In addition, most banks do not appear to incorporate due but unverified receipts, let alone failed receipts, in their measures of outstanding exposure with a counterparty. As a result, many banks do not recognise that they can routinely incur foreign exchange settlement exposures equivalent to several days’ trades, and that these exposures can persist overnight, and therefore over weekends and holidays.23

The Report reveals that only a few banks surveyed expressed interest in implementing an internal measurement system like the one described previously for defining and measuring foreign exchange settlement exposure. Banks seem to be concerned mostly “about the cost of such a system, particularly one that would continually update a bank’s global exposure as it executes each new trade and as each unsettled trade moves through the settlement process.”24

Risk controls. The survey indicated that some banks do not impose limits at all on their foreign exchange settlement exposures, no matter how they are measured. As for those banks that do have limits, some use them effectively, while others set them at extremely high levels or waive them altogether for their largest trading partners.

In addition, some banks impose binding settlement limits, particularly on certain counterparties or in special circumstances, while others use such limits only as guidelines. In general, banks with foreign exchange settlement limits tend to set them with an eye to preventing unusual trading activity rather than containing credit and liquidity exposure.25

Consequently, limits and actual foreign exchange settlement exposures can be much higher than those seen for products with similar risks, such as overnight placements and deposits involving the same counterparties.

It appears from the survey that, while some banks are considering imposing new settlement limits, they are concerned that it would be difficult to hold their counterparties to such limits if others in the market did not do the same thing.

Prospects for individual action. Also, many banks seem not to have “clearly established responsibility for managing foreign exchange settlement risk within their institutions, and so have not created the authority and incentives to control it prudently. While some bankers plan to spend the necessary time and money to improve their settlement practices, others do not and see little incentive to change their practices without a strong mandate from their senior management.”26

Description of Group of Ten Strategy as Set Forth in the Report

This part examines the Report’s specific recommendations. Building upon the results of the market survey and the past work of the Group of Ten central banks on international payments arrangements (most notably the Angell, Lamfalussy, and Noel Reports), the Committee on Payment and Settlement Systems constructed, and the Group of Ten governors endorsed, the following three-track strategy:

  • action by individual banks to control their foreign exchange settlement exposures;

  • action by industry groups to provide risk-reducing multicurrency services; and

  • action by central banks to induce rapid private sector progress.27

Action by Individual Banks to Control Their Foreign Exchange Settlement Exposures

The Report urges individual banks to take immediate steps to improve their current practices for measuring and managing their foreign exchange settlement exposures. The Report suggests the following:

  • measuring foreign exchange settlement exposures as trades move through the settlement process;

  • applying a credit control process to foreign exchange settlement exposures consistent with its control process for managing other credit exposures. For this to work, a bank would need to accept the proposition that foreign exchange settlement exposure represents the same credit risk, and the same probability of loss, for the bank as a loan of identical size and duration with the same counterparty; and

  • reducing excessive foreign exchange settlement exposures for a given level of trading by improving settlement practices.28

For instance, by eliminating overly restrictive payment cancellation deadlines and shortening the time it takes to identify the final and failed receipt of bought currencies, a bank could lower its actual and potential foreign exchange settlement exposure for the same level of foreign exchange trading. Depending on a bank’s trading pattern, the use of available bilateral or multilateral obligation netting arrangements could reduce exposures even further. If necessary, in certain cases a bank may further protect itself against excessive foreign exchange settlement exposures by, for instance, requiring collateral from its counterparties.29

Central Bank Policy Perspective on Individual Action

This type of private sector response focused at the individual bank level provides certain advantages and benefits from a central bank policy perspective. For instance, it can be effected immediately and makes use of the traditional strength of individual banks in reaching informed credit judgments and in pricing and controlling credit risk properly. It allows a bank to make more measured adjustments to its foreign exchange settlement exposures with counterparties in response to its evolving financial condition, which could help stabilize money markets, reduce liquidity pressures, and contain systemic risk at times of market stress.30

Moreover, the envisioned action by individual banks would not require modification of the underlying payments system infrastructure, so that domestic monetary policy implementation should not be affected. Finally, a marketwide increase in the desire of individual banks to lower their foreign exchange settlement exposures should also encourage competition in the quality of correspondent banking services and stimulate private sector innovation.31

In focusing on action that could be taken by individual banks to reduce foreign exchange settlement exposure, the drafters of the Report found that much promising work on foreign exchange settlement risk had already begun. The New York Foreign Exchange Committee (the NYFEC), a group sponsored by the Federal Reserve Bank of New York, which includes as its members individuals from commercial banks, investment banks, and other private organizations, released a study showing that foreign exchange settlement risk, long believed to be an intraday risk, is in fact an overnight risk.32 This study documented for the first time the considerable impact of market practices on the size and duration of foreign exchange settlement exposure. It included recommendations on how private sector market participants can themselves reduce foreign exchange settlement risk by improving internal procedures.33 The NYFEC developed over a dozen recommended best practices to help the industry and individual banks reduce foreign exchange settlement risk.

The study also found that netting is a powerful tool for active market makers. Legally binding netting of payments enables market makers to reduce significantly the enormous sums that are at risk on any given day.

Finally, the NYFEC concluded that for most firms the current finality rules of the local payments systems are an important factor in determining the extent of settlement risk. In fact, for firms operating with close-to-current best industry practices, settlement risk could be decreased if full intraday finality prevails. When it does, final payments could, if necessary, be made and reconciled much sooner. This change, in turn, would shorten the duration of settlement risk.

Action by Industry Groups to Provide Risk-Reducing Multicurrency Services

In addition to encouraging action by individual banks, the Report encourages industry groups to develop multicurrency services that “would contribute to the risk reduction efforts of individual banks and reduce systemic risk more broadly.”34 This recommendation recognizes “the significant potential benefits of multicurrency settlement mechanisms and bilateral and multilateral obligation netting arrangements.”35 The Report reflects the view of the Group of Ten central banks that “such services would best be provided by the private sector rather than the public sector.”36

“Foreign exchange settlement exposure could be attacked at its source by creating one or more multi-currency settlement mechanisms that establish a direct relationship between the payment of one currency and the receipt of another.”37 The Noel Report asserted that this kind of delivery-versus-payment (or, in this context, payment-versus-payment (PVP)) mechanism would assure participants that “a final transfer in one currency occurs if and only if a final transfer of the other currency takes place.”38 The drafters of the Report indicate that they believe a multicurrency PVP settlement mechanism can potentially eliminate foreign exchange settlement exposure. However, they indicate that a PVP mechanism “would not necessarily reduce or eliminate the liquidity or other risks that can arise when settling foreign exchange trades …”39 PVP also does not address the practical timing problems of coordinated cross-border payments and settlements. Central banks considering a potential multicurrency system should evaluate the proposed design of the system to ensure that it does not increase certain risks while reducing others.

The Group of Ten central banks recognize that “the successful creation of multi-currency settlement mechanisms would require cooperation between market participants and central banks, since all these parties need to be concerned with the safety and soundness, as well as the economic viability, of any multi-currency settlement system.”40 At the end of this chapter, some of the Committee’s specific recommendations for central bank cooperation are addressed.

The Report also points out that the risk-reducing benefits of any multicurrency settlement mechanism can be magnified when combined with bilateral or multilateral obligation netting of the underlying foreign exchange trades. Legally valid obligation or payment netting reduces the number and size of settlement flows and, therefore, reduces the intraday liquidity needs for settling those trades through a multicurrency settlement mechanism. Depending on the circumstances, however, problems in either the netting arrangement or the settlement mechanism can have an adverse impact on the other. Accordingly, the integrity of both the settlement mechanism and the netting arrangement must be sufficiently strong to ensure that the combined arrangement does not create greater problems than it solves.

Bilateral Netting Services

FXNET,41 the Society for Worldwide Interbank Financial Telecommunication (SWIFT), and VALUNET currently provide bilateral obligation netting services to many banks.42 In addition, many banks have set up on their own bilateral netting arrangements using a standardized contract, such as the International Foreign Exchange Master Agreement.43

However, despite the potential risk-reducing benefits, the market survey indicated that not all banks use bilateral obligation netting agreements. When they do net, more often than not their netting is limited to close-out provisions (mainly to take advantage of favourable capital treatment of netted positions or to improve their leverage ratios), while routine settlements continue to be conducted on a gross, trade-by-trade basis. Obligation netting44 is mostly confined to the largest banks and their largest counterparties.45

Multilateral Netting and Settlement Services

ECHO (Exchange Clearing House) began operations in August 1995 and the proposed Multinet International Bank hopes to start in 1996.46 Both systems are designed to transform bilaterally arranged individual foreign exchange trades into multilateral net settlement obligations and to provide risk controls that ensure the timely settlement of these obligations. In essence, these controls are designed to reduce credit and liquidity risks by assuring participants that the final settlement of each currency will take place even if a participant in the group is itself unable to settle its obligations on the due date.

ECHO began operations with 16 participant users in 8 countries netting trades in 11 currencies. ECHO hopes to expand its services to banks in more than 20 countries for trades in 25 currencies. Multinet plans initially to provide services to 8 banks in North America for their trades in U.S. and Canadian dollars and other major currencies within the first year. Multinet also hopes to add further currencies and participants in other countries over time. It may be noted that central banks have successfully used the minimum standards and cooperative oversight principles set out in the Lamfalussy Report when reviewing these systems.47

Other Multicurrency Settlement Mechanisms

The “Group of Twenty,” formed in 1994 and composed of international commercial banks from Asia, Europe, and North America, has actively been exploring other possible multicurrency settlement mechanisms. The purpose of the group is to develop private sector mechanisms for reducing risk and increasing efficiency in the clearance and settlement of linked transactions, primarily originating from foreign exchange activity.48

Rather than directly netting the underlying foreign exchange trades, the models currently under study could be designed to support the settlement of individual trades or trades which have already been netted under other bilateral or multilateral obligation netting arrangements. Although these multi-currency settlement mechanisms would not, by themselves, provide the risk-reducing benefits of obligation netting, they could lower credit risks by assuring participants that the final transfer of one currency will occur if and only if the final transfer of the other relevant currency also occurs. Multi-currency settlement mechanisms could also, if designed accordingly, lower liquidity risks by assuring participants that if they settle their payment obligations then they will receive their expected funds on time.49

Prospects for Collective Action

The Report points out that, although some of these industrywide initiatives are well under way, it appears:

Many banks remain skeptical about the business case for committing resources to efforts to reduce foreign exchange settlement exposures. As a result, many individual banks have been slow to join these efforts. Without adequate motivation for a sufficient number of foreign exchange market participants to support and use one or more of these current or prospective industry-wide multi-currency services, their short-term (let alone long-term) viability is uncertain.50

Action by Central Banks to Induce Rapid Private Sector Progress

The final section of the Report that is to be addressed here outlines proposals for central bank involvement in encouraging rapid private sector progress in this area. The Report encourages central banks to facilitate progress by promoting private sector understanding of what banks can do individually and collectively to reduce foreign exchange settlement exposure. Central banks are also encouraged “to work cooperatively with industry groups seeking to develop well-constructed multi-currency services (e.g., multi-currency settlement mechanisms and bilateral or multilateral multi-currency obligation netting arrangements) that would be widely available and would help banks control their foreign exchange settlement exposures on a routine basis.”51

Most notably, the Group of Ten central banks have indicated a willingness to cooperate with industry groups in several ways, including

  • extending the operating hours of domestic payments systems;

  • clarifying and, where possible, resolving legal issues and cross-border collateral issues; and

  • considering, where appropriate, granting access to settlement accounts and central bank credit and liquidity facilities to sound multicurrency settlement mechanisms or to their members.52

Finally, the Report indicates that the Group of Ten central banks plan to facilitate private sector action by seeking the following key enhancements to national payments systems:

  • Clarification of the times at which payment instructions become irrevocable and receipts become final in the settlement of foreign exchange transactions through home-currency payments systems or book-entry transfers on the accounts of correspondent banks

  • Provision, where not now available in at least one large-value payments system, of an intraday final transfer capability or its equivalent

  • Removal of obstacles (e.g. early cut-off times for third-party transfers) that inhibit payments system direct members from acting upon late-day customer payment instructions for same-day value

  • Strengthening, as necessary, of the risk management arrangements of privately operated systems used to settle foreign exchange transactions.53

Domestic Strategies

In addition to these measures, the Report indicates that “each central bank, in cooperation, where appropriate, with the relevant supervisory authorities, will choose the most effective overall strategy to stimulate satisfactory private sector action over the next two years in its domestic market.”54

This strategy could include, after proper consultation,

supervisory measures to persuade individual banks to control their foreign exchange settlement exposures. If appropriate and feasible, one or more of the following measures could be taken:

  • Supervisory guidelines for measuring foreign exchange settlement exposures in a manner consistent with the proposed methodology

  • Regular confidential reporting of properly measured foreign exchange settlement exposures

  • Regular public disclosure of properly measured foreign exchange settlement exposures

  • Supervisory guidelines regarding the prudential management and control of properly measured foreign exchange settlement exposures

  • Verification of compliance with the selected measures through bank examination and audit reports

If necessary, one or more of the following stronger supervisory measures might also be considered:

  • The enforcement, by statute where available, of the use by individual banks of mechanisms to control their properly measured foreign exchange settlement exposures. This could include the setting of formal limits on those exposures

  • Consideration, by agreement with banking regulators (G-10 and EU), of foreign exchange settlement risk in the set of risks subject to capital adequacy requirements

  • The enforcement or imposition (by agreement with the relevant supervisors) of comparable measures applying to non-bank regulated financial institutions active in the foreign exchange market55

Central Bank Perspective on Central Bank Action

The views of the Group of Ten central banks on the strategy just described may be summarized as follows:

  • The private sector should be encouraged and supported to improve settlement practices in individual institutions and on a marketwide basis.

  • The home country central bank or the appropriate supervisory authorities should induce action by individual banks.

  • “At the industry group level, central banks plan to cooperate, where appropriate and feasible, with those existing and prospective private sector groups that would like to provide risk-reducing multi-currency services…. When working with industry groups to bring about the identified key enhancements to national payments systems, central banks would need to guard against possible side effects.”56

  • “The Group of Ten central banks believe that the private sector can adequately address the systemic risk inherent in current practices for settling foreign exchange transactions.”57 Through the Committee on Payment and Settlement Systems, these banks will closely monitor progress during 1996-98 and assess the need for further action.

Legal Issues Raised by the Foreign Exchange Settlement Risk Report

Several legal issues are raised by the Report’s recommendations.

Finality and Choice of Law

The Report urges a bank to distinguish and track when its payment instructions can no longer be cancelled unilaterally and when it has received currency with finality.58

In order to track the status of its trades to finality, a bank will have to resolve two significant legal issues: first, it will have to determine with some degree of certainty what substantive law will govern its rights and duties and those of its counterparties and intermediaries; and second, the bank will have to determine when and whether a sufficient degree of finality has been achieved under the applicable law.

The choice of law question, as it relates to the finality of payment transfers, could be addressed if countries adopted choice of law provisions such as those in the 1992 Model Law on International Credit Transfers (the Model Law) prepared by the United Nations Commission on International Trade Law (UNCITRAL).59 No country has adopted a law similar to the Model Law (other than the United States, in the form of Article 4A of the Uniform Commercial Code).60 The Model Law and Article 4A are similar on the choice of law issue.61

The basic rule set forth in Article 4A on choice of law is that parties to a funds transfer are free to choose the law of any jurisdiction to govern their rights and obligations.62 This applies equally to the choice of substantive law selected by the rules of a funds transfer system, which would apply to participating banks and a nonparticipant party (for example, originator, other sender, receiving bank, or beneficiary) to a funds transfer that has notice that the funds transfer system might be used for all or part of the transfer.63 The rights and obligations covered by these choice of law rules would include whether and when a payment order becomes irrevocable.

Where a conflict of laws exists, for example, in the case where settlement of a foreign exchange transaction involves two funds transfer systems with differing choice of law provisions in their rules, Article 4A specifically provides that the matter in issue is governed by the law of the selected jurisdiction that has the most significant relationship to the matter in issue.64 This rule adopts the “most significant relationship” test that seeks to break a deadlock by supporting the substantive rules of the jurisdiction with the greatest policy interest in the underlying dispute.

Where no choice of law exists, in either an agreement between the parties or a funds transfer system rule, Article 4A provides that the law of the jurisdiction in which the receiving bank is located governs the rights and obligations of the sender and the receiving bank.65 For purposes of determining location, a branch or separate office of a bank is viewed as a separate bank.66

With respect to finality, if the parties cannot determine whether a particular payment transfer will achieve finality under the applicable substantive law, their efforts to reduce foreign exchange settlement exposure may be for nothing. Generally, finality may be defined as the point at which an irrevocable and unconditional transfer effects a discharge of the obligation to make the transfer.67 A credit transfer might be considered final when, as a matter of the governing law, the originator’s payment order becomes irrevocable, the beneficiary’s bank has unconditionally assumed the obligation to pay the beneficiary, and the beneficiary has unconditionally agreed to accept the credit institution’s obligation in discharge of the originator’s payment obligation.68 This type of finality would define where and when, as a matter of ordinary commercial law, credit risk comes to rest in a particular transaction. It is that point that must be defined with sufficient certainty for a bank to effectively measure its foreign exchange settlement exposure. Essentially, the exposure is “live” from the time the bank issues an irrevocable payment order with respect to the sold currency until it receives the bought currency with finality.

In the United States, efforts to harmonize domestic rules governing wholesale wire credit transfers resulted in Article 4A. The law covers Fedwire and the Clearing House for Interbank Payments System (CHIPS). The purpose of the law was to promote efficiency in, and bring certainty to, the law governing wholesale funds transfers. Under Article 4A, a funds transfer is completed when a beneficiary’s bank has accepted a payment order for the benefit of the beneficiary.69 Once the beneficiary’s bank accepts the payment order, as a general rule, it cannot be cancelled or amended.70 It should be noted, however, that some uncertainty exists in the United States as to the applicability of Article 4A to foreign exchange transactions. Some courts have held that Article 2 of the Code, which relates to the sale of “goods,” applies instead.71 Efforts are under way to clarify the applicability of Article 4A to foreign exchange transactions.

Finality may also be threatened by the application of noncontractual legal powers. For example, so-called zero-hour bankruptcy rules can cause transfers that achieved “contractual finality” between the zero hour and the moment of bankruptcy to be reversed as a matter of bankruptcy law. The draft proposal for an EU directive on settlement finality and collateral security72 would specifically supersede any zero-hour bankruptcy rule that would have a retroactive effect on a participant’s rights and liabilities in connection with EU payment systems.73


The Report also points out the importance of netting. Specifically, the Report states that the risk-reducing benefits of any multicurrency settlement mechanism can be magnified when combined with bilateral or multilateral obligation netting of the underlying foreign exchange trades.74 Banks can also bilaterally net the settlement obligations arising out of their foreign exchange trades rather than settling them on a trade-by-trade basis. Such bilateral obligation netting could directly reduce the amount of risk by lowering the number and size of payments that would otherwise be needed to settle the underlying transactions. In order for netting to provide the benefits discussed by the Report, the netting must have a sound legal basis. A greater degree of legal certainty has been introduced through recent statutory developments that serve to strengthen the legal foundation for netting in the United States.

The netting provisions of the Federal Deposit Insurance Corporation Improvement Act of 1991 (FDICIA)75 apply to bilateral netting contracts between financial institutions and multilateral netting contracts among clearing organization members.76 Title IV of FDICIA makes clear that netting contracts are enforceable notwithstanding any other provision of law.77

The term “netting contract” covers agreements to net payments as well as to net and closeout over-the-counter and other transactions.78 The term also includes the rules of a clearinghouse.79

FDICIA defines the term “financial institution” as a depository institution, a securities broker or dealer, a futures commission merchant, and other institution as determined by the Board.80 The Board has expanded this definition through its promulgation of Regulation EE to include a broader range of market participants.81 Regulation EE provides that any entity that meets certain tests based on market activity would qualify as a financial institution under FDICIA.82 Most dealers in the over-the-counter derivative and foreign exchange markets would qualify as financial institutions under either the statutory or regulatory definition.

Since the publication of the Lamfalussy Report,83 the legal status of netting has noticeably improved in most of the Group of Ten countries, in particular due to new legislation. Specifically, Belgium,84 Canada,85 France,86 Germany,87 the Netherlands,88 Sweden,89 Switzerland,90 the United Kingdom,91 and, as just noted, the United States92 have enacted legislation to ensure the enforceability of netting arrangements or closeout mechanisms. New legislation on netting is envisaged in other countries. In Japan, no change in legislation is envisaged for the time being, because netting under existing rules for setoff is considered to have a sufficient legal basis.

In the Group of Ten countries, bilateral netting arrangements for payments exist and are in common usage. Bilateral payment netting seems to rely on well-founded legal mechanisms, such as novation, setoff, or current account,93 which have their sources in general (civil or commercial) legislation or in long-established jurisprudence.

The bankruptcy laws of some Group of Ten countries include a zero-hour rule, which voids payments of an insolvent entity with retroactive effects to the zero hour on the day of commencement of an insolvency procedure. The effect of such a retroactive rule is that the receiver is either permitted, or required to seek, reimbursement of any payment made on that day by the insolvent debtor and, therefore, may, or must, challenge the results of netting arrangements through which such payments have been made. Some of these countries have enacted specific provisions to overcome the zero-hour rule as far as interbank payments are concerned.

Multilateral netting of financial obligations is a largely untested field because of lack of both practical experience and judicial decisions. The legal analysis of such netting arrangements may not be very different from the analysis concerning bilateral netting of financial obligations.

Cross-Border Issues

Cross-border issues arise when there is a conflict between the law governing the netting arrangement and the potentially different laws applicable to the parties, particularly in connection with bankruptcy. The problem becomes even more complex by the fact that there is no uniformity in the determination of the law applicable to the bankruptcy of a party in a netting arrangement of an international nature. It is possible that several bankruptcy courts at once may consider themselves as having jurisdiction. This depends mainly on which principle of international bankruptcy law is applied in a particular jurisdiction.

Two main systems exist in the Group of Ten countries—the universality approach and the territoriality approach. The universality approach means that domestic insolvency proceedings also include, in theory, assets located abroad and that winding-up proceedings by domestic courts are conducted on a global basis. Under the territoriality approach, bankruptcy proceedings are effective only in the country in which they are opened, and, therefore, proceedings also have to be opened in every country in which the bankrupt holds realizable assets. It should be noted that many variants of each system exist, and “in practice most developed states adopt a combination of these extremes.”94

International Coordination of Insolvency Legislation


In Europe, several efforts have been made to coordinate insolvency legislation. The Convention on Insolvency Proceedings (the Convention)95 and the draft Winding-Up Directive96 are of particular interest. The Convention had been signed by all member states of the European Union, except the United Kingdom, Ireland, and the Netherlands, by April 1996. However, since not all the EU member states signed the Convention by the May 23, 1996 deadline, it did not enter into force.97

Both the Convention and draft Directive apply the insolvency law of a bankrupt person’s home state across Europe, regardless of the location of the assets and the persons who have dealt with the bankrupt.98 Under the Convention, secondary proceedings can sometimes take place in states where there are “establishments.”99 Establishment is defined as “any place of operations where the debtor carries out a non-transitory economic activity with human means and goods.”100 Secondary proceedings begun after insolvency proceedings have started in the home state can only be liquidation proceedings.101 The Convention applies to all entities except banks, insurers, mutual funds, and investment firms.102

There is a list of issues concerning those that the Convention may apply instead of the home state law, the law of another contracting state. These issues include security rights,103 contractual netting,104 retention of title,105 protection of financial markets,106 employees’ rights,107 and the right to attack preinsolvency transactions.108 It should be noted that because of the uncertainty about the Convention’s provision on setoff,109 it is unclear whether the Convention would have any effect on netting agreements.

The Winding-Up Directive applies to insolvencies of banks.110 It is still in draft but is progressing rapidly toward a common position agreed by the EU member states, from which the formal EU legislation process will begin. The Winding-Up Directive contains an express provision that ensures that the effect of insolvency proceedings on contractual netting agreements is to be governed by the law of the netting agreement.111


The UNCITRAL Working Group on Insolvency Law is currently working on an international insolvency law to take the form of an international agreement, an international law, or a treaty. The work is at its early stages. One of the issues that will have to be discussed at great length involves the provision of an automatic stay.112 Under U.S. law, financial contracts are exempt from automatic stay.113

Access to Collateral

Important legal issues also arise with respect to collateral. Financial market participants and foreign exchange clearing organizations must satisfy themselves with a high degree of certainty of their ability to retain, liquidate, and apply collateral pledged to them by counterparties to secure their obligations under netting contracts. In order to be assured that collateral security will be available in the event of insolvency of a counterparty, it is necessary to determine that the insolvency laws applicable to that counterparty will not hinder or delay access to collateral.

Once a counterparty is declared insolvent, several events can occur that could potentially hinder the nondefaulting counterparty’s rights in the collateral. For example, an automatic stay, or the receiver’s right to take possession of all the assets of the insolvent counterparty (including collateral pledged by it to secure its obligations under a netting agreement), poses serious problems for the solvent party.

In the United States, legislation was enacted that has addressed these problems by giving special protections to qualified financial contract counterparties. Special provisions were added to the Federal Deposit Insurance Act (which covers insured depository institutions) in 1989 protecting qualified financial contracts.114 A qualified financial contract is a securities contract, a commodity contract, a repurchase agreement, a swap agreement, or any similar agreement as determined by the Federal Deposit Insurance Corporation (FDIC).115 The FDIC, in 1995, adopted a rule to include spot and other short-term foreign exchange agreements and repurchase agreements on qualified foreign government securities within the definition of qualified financial contract.116

Qualified financial contract counterparties retain certain rights under their contracts with insured depository institutions, subject to certain transfer powers of the FDIC. These rights may differ depending on whether the institution is in receivership or conservatorship. Specifically, in a receivership a qualified financial contract counterparty may exercise (i) any right to terminate or liquidate a qualified financial contract that arises upon the appointment of the FDIC as receiver, (ii) any right under a security agreement related to such a qualified financial contract, or (iii) any right to offset or net out obligations under a qualified financial contract.117 The rights of qualified financial contract counterparties versus a conservator are subject to the FDIC’s authority to enforce a contract notwithstanding any contractual provision that allows termination and closeout solely by reason of the appointment of a conservator.

The United States Bankruptcy Code covers bankruptcy proceedings of individuals, partnerships, and corporations (other than depository institutions and insurance companies).118 The Code provides for an automatic stay of all actions against the debtor or the property of an estate upon the filing of a petition.119 However, there are exceptions to the automatic stay in the Code, and there are provisions permitting the setoff120 and termination of specific types of financial contracts.121 These exceptions are available only for specific types of counterparties. They are: (i) securities contracts by stockbrokers, financial institutions, or securities clearing agencies; (ii) commodity contracts or forward contracts by commodity brokers or forward contract merchants; (iii) repurchase agreements by repo participants; and (iv) swap agreements by swap participants.122

Pledging of Securities

Financial market participants also need to determine in advance with sufficient certainty the substantive law that will govern their rights and obligations or those of possible adverse claimants with respect to securities that are pledged to them. Once the governing substantive law has been ascertained, financial market participants need to be certain that they have a distinct package of rights that cannot successfully be attacked by adverse claimants. One authority, Randall Guynn, has argued that “most national laws governing the ownership, transfer, and pledging of securities have become obsolete and should be modernized …”123 He notes that most current laws do not allow investors or secured creditors to have this kind of certainty.124 He takes the position that a set of national laws must be put in place

that allows issuers, investors, and secured creditors to determine in advance—with certainty and predictability—the substantive law that will govern their rights and obligations and, perhaps most importantly, those of possible adverse claimants. It should also allow them to become certain that they have a distinct package of rights that cannot successfully be attacked by an adverse claimant once they have taken certain clearly defined and reasonable actions.125

In the United States, Revised Article 8 of the Code126 is one such national law that provides certainty in this area. It has been enacted in several states in the United States and is pending for consideration in several others. Guynn has also found that there are two other national laws that could serve as models for reform in other countries: Belgian Royal Decree No. 62 dated November 10, 1967, Facilitating the Circulation of Securities (as amended April 7, 1995) and the Luxembourg Grand-Ducal Decrees of February 17, 1971, December 18, 1991, and June 8, 1994.127 Guynn states:

Perhaps the most important innovation of each of these laws is that they define a person’s interest in securities held through any or certain types of financial intermediaries in terms other than traceable property rights in individual securities or mere contractual claims. Each defines such interests (with more or less clarity) as a property interest that is evidenced solely by an accounting entry on the books of the interest holder’s intermediary and that does not include traceable property rights in individual securities. This innovation should promote the finality of transfers and pledges made by book entry to accounts with an intermediary and substantially increase the certainty and predictability of existing conflict of laws rules.128


Foreign exchange settlement risk can be reduced by the following three-track strategy.129 First, individual banks can control their foreign exchange settlement exposures by applying appropriate credit control processes. Second, industry groups can develop well-constructed multicurrency services that contribute to the risk-reduction efforts of individual banks. Third, central banks, in cooperation with the relevant supervisory authorities, can foster private sector action. The Group of Ten central banks recognize that cooperation between market participants and central banks is necessary to address the systemic risk inherent in current practices for settling foreign exchange transactions. In the Report, they endorse the three-track strategy.130

In conclusion, while perspectives of the risks and challenges may differ, the objectives of supervisors and market participants, as financial intermediaries and users of financial services, are the same, pointing toward maintaining a vibrant and strong financial system over the long term.