How do we mitigate the derivatives market counterparty risk that played a starring role in the global financial crisis?
Treasury Secretary Geithner should look to the international foreign exchange market for a proven regulatory model. This counterparty marketplace not only did not freeze up during the global financial crisis but also expanded trading volume by 30% during the heart of the crisis as other markets collapsed completely.
Why did the foreign exchange market expand when other markets contracted and even failed, and what can we learn from this market's success story to shore up the derivatives market today?
During the early 1970s the historic practice of bilateral trading, clearing and settlement created a shock for the foreign exchange market that prompted an unprecedented innovation. A new private institution called the Continuous Linked Settlement Bank was ultimately started in 2002 to counteract the market's risks and to protect it, even in the face of a global financial crisis.
It is easy to appreciate that foreign exchange trading involves many risks. Like other asset prices, exchange rates are volatile, so positions change in value moment by moment. And credit risk within foreign exchange transactions can be a far more serious, and even fatal, blow to a trading bank. Surprising as it may seem, this risk is in large part due to time zone differences and the fact that every foreign exchange transaction has two legs that occur in different countries.
For example, suppose a U.S. bank (let's call it Yankee Bank) enters into a trade with a Japanese bank (we'll call it Samurai Bank). Yankee sells 100 million yen to Samurai for $1 million, with delivery on Wednesday, Feb. 25. On the delivery day, Yankee arranges to deliver 100 million yen to Samurai in Tokyo. This delivery takes place during Tokyo business hours, say, 10 a.m. local time. When Yankee's leg of the transaction is completed, it would be 12 to 13 hours earlier in New York, meaning 9 or 10 p.m. the prior day, when New York banks and the Federal Reserve are closed. It could be another 12 to 13 hours before Samurai's $1 million payment is delivered in New York. And during those hours, lots of things could happen, including the failure of Samurai Bank. If that were to happen, Yankee Bank would suffer a complete loss, having paid out 100 million yen to Samurai but receiving nothing in return.
This scenario might seem dire and improbable. But it has actually happened more than once in the foreign exchange market, most famously in 1974 with Herstatt Bank, a privately owned institution in Cologne, Germany. On June 26, 1974, counterparty banks around the world paid deutsche marks to Herstatt in Cologne, expecting it to pay out U.S. dollars during local banking hours in the United States. But Herstatt declared bankruptcy on June 26 and never fulfilled its leg of these transactions, leaving numerous institutions (for example, Morgan Guaranty Trust, Seattle First National and Hill Samuel) with losses in the tens of millions of dollars each.
This type of credit risk — time-zone risk or "Herstatt risk" — has two key elements. First, in the 1970s banks relied on a multilateral clearing system. Each of the hundreds of banks trading potentially had counterparty transactions with hundreds of other banks, creating thousands of bilateral transactions. One failed bank could affect dozens or hundreds of counterparties.
And second, time zone differences meant that banks further along in the 24-hour trading day were at risk from a bank failure in an earlier time zone.
The innovation that solved the Herstatt risk problem is at once quite simple and also quite sophisticated. In foreign exchange, the CLS Bank uses a payment-versus-payment system, whereby payments from Yankee Bank to Samurai Bank (and vice-versa) are not made bilaterally as before but rather paid to the CLS Bank. Only when both legs of the transaction are received does the CLS Bank make irrevocable payments to both counterparties. If one counterparty fails to produce its leg of the transaction, the other counterparty's funds are returned in whole, thus averting the Herstatt risk.
On its peak day in September 2008, the CLS Bank handled more than 1.5 million instructions and settled transactions with a gross value of $8.6 trillion. And as with the dog who didn't bark, very few of us noticed the activity and efficiency of the CLS pipeline that protected the foreign exchange market from freezing up.
A semiannual market survey prepared by the New York Foreign Exchange Committee said overall foreign exchange trading volume in New York grew 8.7% in October 2008 from the year earlier. Data for London showed overall daily trading volume rising 21% from the level of October 2007.
If the concern over bank creditworthiness had spread to foreign exchange, it would have dealt a serious blow to global trade and real economic activity over and above the impact of the financial crisis itself.
The credit standing and operating efficiency of the CLS Bank is beyond reproach. It is a New York-based private institution owned by a consortium of roughly 70 member banks from 22 countries, and it operates under Federal Reserve Bank regulation.
In addition to 60 settlement members, more than 4,000 other institutions participate in the system. The CLS Bank handles trades in 17 CLS-eligible currencies among CLS-eligible counterparties.
It took many years and a substantial investment to develop and build the CLS Bank system. But this institution has clearly proved its worth, and it offers a proven model for handling counterparty risk.
With a CLS-like derivatives bank, we could offer the financial system a model that is almost as safe as government but that is managed by the private sector with regulatory oversight. And with less risk, banks would need less capital to support derivatives trading, providing a natural incentive to use the new system.
We have a tried-and-true model already. It is time to put it into practice.