^{While Lee Oliver, Euromoney’s FX correspondent, is on summer break, the weeklyFiX is supplied by guest writers from the industry. Our first contributor is Jonathan Butterfield, executive vice -president, marketing and communication, CLS Bank International.}

As we approach the first anniversary of the onset of the worst bout of financial instability for years, we continue to witness roller-coaster conditions across financial markets and a  credit crunch that is having a wider impact on the broader economies of many developed countries. The financial markets are having to address market, credit (counterparty), operational and liquidity risk management as a top priority. This has inevitably led to an evaluation of the issues around trading from execution to clearing and settlement in the instruments that have proved so toxic. 

The increased focus on risk in the current climate means that settlement and operational risk has rapidly climbed up the agenda, arguably to an unprecedented level. The recent report from the President’s Working Group on Financial Markets (PWG) and comments by Timothy Geithner,  president of the New York Federal Reserve demanding robust and speedy action to improve risk management and operational controls over various trading activities  have added greater urgency to improving post trade practices.  Counterparty risk used to be the subject of bi-annual reviews, now it is a daily activity for senior managers. More than ever, the regulatory community is pulling together and re-invigorating its efforts to drive the industry towards further improvement and the adoption of more stringent standards.

The reality is that settlement risk numbers dwarf any other risk category in many institutions. In some cases, large banks have almost three times more exposure to settlement risk than to credit risk. The sums of money are huge. In FX, the largest market by value, transactions can involve settlement exposures amounting to tens of billions of dollars each day to individual counterparties and, in some cases, exposure to a single counterparty exceeds that institution’s capital.

The inclusion of settlement practices and deficiencies in the PWG is quite a step up for what has often been referred to as the plumbing. Previously, the processes that follow a trade were left to the middle and back offices and assumed to be under control. In the current climate there is huge pressure to ensure a far higher degree of precision in calculating exposures and then assessing how to fund the respective settlement cycles.  Nervous and tight credit markets failing to settle, even for the most mundane reasons, can have catastrophic consequences. Given the parlous state of the current financial markets, it is perhaps no surprise that these operational elements have been one of the areas of concern highlighted by the US Treasury-sponsored working group.

So, while the derivatives markets are working hard to tighten up post-trade procedures and standards, FX offers an example of an industry which has taken the lessons learned from earlier failures and acted on them, albeit under significant regulatory pressure at the time, which sounds all too familiar! FX’s history had highlighted all too painfully the downside of settlement risk when a counterparty defaults and leads to massive losses. It was the collapse of Herstatt in the 1970s and the continued growth in trading that provided the impetus for a robust private sector solution to be put in place – CLS Bank – that has been up and running for nearly six years.