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BIS: Banks ‘must lessen FX transaction default risks’

Investment banks active in FX trading are underestimating principal risks and other transaction risks tied to the market, warns the Bank of International Settlements.

As such, the banks should be required to take larger amounts of collateral from trading partners to lessen risks associated with failed currency transactions, according to new draft guidance issued by the Basel Committee on Banking Supervision. If adopted by the committee, the draft guidance, released on Friday, would replace FX market guidance adopted by the group in 2000.

The new draft is generally in line with Basel III stipulations that banks hold more capital on their books to insure against the default of a variety of market transactions, and to require CCP clearing of a variety of derivatives and other electronically traded securities.

The draft guidance stipulates that banks should actively manage risk associated with FX transactions by measuring, monitoring and controlling default risk or replacement-cost risk in a trade until settlement of the trade is confirmed and reconciled.

“A bank should use legally enforceable netting agreements to reduce its replacement-cost risk, where practicable,” states the committee in the guidance.

As such, taking more collateral off counterparties would be one way to lessen risks associated with FX transaction defaults, and banks should work to decide what forms of new eligible collateral could be used to mitigate replacement costs in addition to existing forms of collateralization, the committee states.

The guidance would promote “the use of payment-versus-payment arrangements, where practicable, to reduce principal risk,” the committee states.

The banks should also have “explicit policies” on haircut and margin levels when setting higher capital-requirement levels for FX trading.

Banks and regulators should also implement the revised guidance to take into account the “size, nature, complexity and risk profile” of their banks’ FX activities, including the potential for spikes in activity in the forex market driven by interbank activity or brokers.

“A bank should confirm the trades in a timely manner, using electronic methods and standard settlement instructions where practicable,” the guidance states.

FX settlement risk – the chance that one party to a trade pays out the currency that it is sold but does not receive the currency it bought – has long been a concern of global central bankers due to its potential to introduce systemic risk into the global financial system.

In 2008, the Bank for International Settlements warned that banks would face greater settlement risk exposure in FX transactions unless steps were taken to limit credit risk in what was then a $3.2 trillion-per-day market. Since then, the market has grown in size to $4 trillion-per-day.

Comments on the new Basel Committee draft guidance must be submitted to the group by October 12.

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