Settlement Risk

In addition to the explicit provision of credit via daylight overdrafts, financial institutions also need to control their exposure to settlement risks incurred through the institutions' participation in interbank payment and settlement systems. In general, settlement risk is the possibility that the completion or settlement of individual transactions or settlement at the interbank funds transfer or securities settlement level more broadly, will not take place as expected. In addition to credit risk, settlement risk often includes elements of liquidity risk.

One important source of settlement risk is any time lag between the origination of the payment or securities settlement instructions and final settlement, and discharge of those instructions. This time difference between the delivery of payment details and payment finality, or settlement lag, creates the possibility that sending institutions could fail during the lag or at least not be able to settle their obligations when due, typically at the end of the day. If the receiving bank credits the anticipated payment proceeds to the customer's account before the payment is final, the receiving bank may be exposed to credit risk from the sending bank until final settlement occurs. As long as final settlement has not occurred, any credits or additional payment activity undertaken on the basis of "unsettled" payment messages results in credit risk.For more information, see "Real-time Gross Settlement Systems," Committee on Payment and Securities Settlement Systems, 1997 at www.bis.org/publ/
cpss22.pdf.
Financial institutions should analyze and control this credit risk as they would any other extension of credit.

Real-Time Gross Settlement systems, such as Fedwire Funds Service, are not subject to this risk as payments credited to a receiver's account are final at the time of receipt. CHIPS payments were previously subject to this kind of risk. However, starting January 2001, CHIPS began sending payment details to the receiving bank only once a payment became final.Receiving banks may, however, request certain details about payments queued for their receipt. Such informa-tion should not be treated as a final payment. Securities settlements that occur at DTC may be subject to this kind of risk.

Another form of settlement risk is caused by a time-lag between the final settlement of two sides of a given trade or transaction (e.g., any difference in timing between the payment for and delivery of securities, or for foreign exchange transactions, the final delivery of one currency prior to the other). Such time lags can put the entire principle value of trades at risk. Several payments and securities settlement systems, including DTC and CLS Bank are designed to avoid this risk. Nonetheless, many foreign exchange transactions are not settled in CLS Bank, and may be subject to this type of settlement risk. Securities settlement systems in other countries in which U.S. institutions participate may also be subject to this form of risk.

Finally, many payments and securities settlement systems, especially those that rely on settlement lags, netting, or intraday credit, often implement various forms of risk controls that have important credit risk implications for system participants. In particular, systems often employ various types of loss-sharing and supplemental liquidity requirements in the event of settlement failures or disruptions. Participants in any payment or securities settlement system should understand the risks related to these settlement failure procedures and should be prepared to make any required supplemental payments of loss allocation assessments as described in the system rules. Financial institutions may also pre-arrange to serve as liquidity providers to payment or securities settlement systems in the event of a settlement disruption. These liquidity arrangements may involve committed lines of credit on either a secured or unsecured basis or foreign exchange swap facilities. Institutions should understand the nature of these special commitments and be well-prepared to act on them.

 

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Liquidity Risk