FX settlement risk reduced for NZ financial system

FX settlement risk reduced for NZ financial system

The Reserve Bank today announced that the New Zealand dollar has today been included in an international system that reduces the risk of things going wrong when substantial foreign exchange transactions are settled across national boundaries.

Financial institutions undertaking foreign exchange transactions face the risk of severe losses if the transaction falls apart part way through. This can occur after one party has transferred funds as its part of a deal and is waiting for the other side of the transaction to be completed. Indeed, overseas there have been examples in the past of financial institutions being bankrupted as a result, and the risk grows when institutions are trading across time zones which can cause delays of many hours between a transaction being initiated and completed – up to 18 hours in New Zealand’s case.

To, as much as possible, eliminate this risk, major international banks have in recent years set up a system known as ‘continuous linked settlement’ (CLS), by which both legs of foreign exchange transactions can be settled simultaneously. This is done through a New York-based multi-currency bank called CLS Bank International (CLS Bank) which holds accounts for each settlement member and an account at each eligible currency’s central bank, through which funds are received and paid. As of today the New Zealand dollar is included in this system.

Reserve Bank Governor Alan Bollard commented “This is a substantial step forward for financial stability in New Zealand. I want to especially thank all those in the financial sector, including the major banks, who have together set up the systems that make this possible. This is a good example of the way the sector can work together. The Reserve Bank’s role has been to encourage and to ensure that the Reserve Bank’s settlement systems can be linked to CLS Bank, but we have needed the support of the financial sector throughout.

This initiative is part of a larger effort to make the New Zealand financial system as sound and efficient as possible,” Dr Bollard concluded.

A fact sheet is attached to this press statement.

Fact Sheet:

Continuous Linked Settlement

Approximately $10.6 billion of NZD foreign exchange contracts are transacted every day. Financial institutions undertaking these transactions face the risk of severe losses if the transaction falls apart before the contract can be finalised. This can occur after one party has transferred funds as its part of the contract and the other party is unable to meet its obligation.

From here on, the bulk of these transactions will take place through the CLS system. This will eliminate this kind of settlement risk in these transactions.[1]

Settlement in CLS Bank occurs in a five-hour window, though for the currencies in the Asia-Pacific region, this is reduced to a three-hour window starting at 5pm New Zealand time (or 7pm during daylight saving time).

The payment flows as at present and in CLS Bank are illustrated in figures 1 and 2 overleaf.

At present the trade is made between the two banks and then settled in two different time zones.

In CLS Bank, the settlements occur at the same time. CLS Bank receives payment instructions from each bank and matches them in its systems. It then generates a payment schedule. Once funds have been received from Bank A and from Bank B into CLS Bank’s accounts, CLS Bank then settles the trade between the two parties. If one party were to default, the trade is not settled and no monies are transferred from CLS Bank to the defaulting bank.

Because there are large numbers of banks and trades being matched within CLS Bank, its matching algorithms enable a high percentage of the trades to be settled on the basis of a net funds flow. The net flows are typically about 25 per cent of the gross flows that would otherwise have occurred outside CLS Bank. CLS Bank has other algorithms and trade processes that enable further reductions to be made, resulting in net flows as low as 5 to 10 per cent of the initial gross payment flows.

The reductions in flows enable banks to make large savings in their liquidity requirements for settling foreign exchange transactions, as well as eliminating the default risk that they otherwise faced with foreign exchange trades settled outside CLS Bank.

CLS Bank in New Zealand has an account in the Exchange Settlement Accounting System (ESAS), and together with ESAS is a designated payment system under the Reserve Bank of New Zealand Amendment Act 2003. By being designated, under New Zealand law all payments made through it will be final and irrevocable. This means they cannot be unwound in the case of bankruptcy of one of the two parties, once the payment has settled.

For more information on CLS go to http://www.cls-group.com.

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