The risk of a major financial institution failing to settle its foreign exchange trades threatens the smooth operation of global markets, a Federal Reserve System governor said in a speech last week.
"Settlement risk involved in foreign exchange remains a weak link, and perhaps the single most problematic one in an increasingly integrated set of world financial markets," said David W. Mullins Jr., vice chairman of the Federal Reserve's Board of Governors, in a talk at a recent conference of the World Economic Forum at Harvard University.
The settlement risk that Mr. Mullins said he was concerned about was the delay between consummation of a foreign exchange trade and the actual transfer of money.
|Freeze Up' of Liquidity
With a trillion dollars of foreign exchange trades taking place daily, Mr. Mullins said that there is a risk that a large player in the market could fail before paying off a major deal.
This could rattle investor confidence, and "dramatically freeze up the liquidity needs of the system," Mr. Mullins said.
Mr. Mullins said that regulators and financial institutions have come to grips with this type of risk in virtually every other heavily traded financial instrument.
But the foreign exchange market is different, Mr. Mullins said.
The best way to minimize settlement risk is to develop some kind of "delivery versus payment" operation, in which the ownership of an instrument changes hands at the same time that funds are moved, Mr. Mullins said.
Such arrangements are aided by computerized systems called book entry, in which paper documents are "frozen," and their ownership is transferred electronically.
But one barrier to instituting a delivery versus payment settlement system in foreign exchange markets is that currencies are traded around the clock in every time zone.
For central banks to facilitate delivery versus payment, they would have to have some way of moving funds 24 hours a day.
Mr. Mullins said that since "he'd like to sleep," he doesn't want to see central banks stay open day and night.
Instead, he said central banks could set up "spread accounts" or "special agency relationships" that provide access to the central banks' services when needed.
Mr. Mullins. added that the private sector could also help by setting up "multilateral netting facilities," in which the largest players in a market work together to minimize the number of funds transfers that need to be executed to pay off trades.
Mr. Mullins said that central banks and market participants "are not really close" to developing the types of clearing and settlement systems he believes are needed to minimize the risk.
But Mr. Mullins added that the Federal Reserve's Board of Governors is more interested in acting on this issue now than it has been in years.
"It's something that I think we're pretty serious about now," Mr. Mullins said.
Mr. Mullins added that this marks a change in attitude from the previous 20 years, where "relatively little has been done."
Mr. Mullins said that the soaring volume of foreign exchange trades, and what he called the "increased volatility in the last year or so" in the market has caused the Federal Reserve to get more interested in the issue.