RBI’s Role in Risk Management and Settlement of Transactions in the Foreign Exchange Market

The Indian Foreign Exchange (Forex) market is characterized by constant changes and rapid innovations in trading methods and products. While the innovative products and ways of trading create new possibilities for profit, they also pose various kinds of risks to the market. Central banks all over the world, therefore, have become increasingly concerned of the scale of foreign exchange settlement risk and the importance of risk mitigation measures. Behind this growing awareness are several events in the past in which foreign exchange settlement risk might have resulted in systemic risk in global financial markets, including the failure of Bankhaus Herstatt in 1974 and the closure of BCCI SA in 1991.

The foreign exchange settlement risk arises because the delivery of the two currencies involved in a trade usually occurs in two different countries, which, in many cases are located in different time zones. This risk is of particular concern to the central banks given the large values involved in settling foreign exchange transactions and the resulting potential for systemic risk. Most of the banks in the EMEs use some form of methodology for measuring the foreign exchange settlement exposure. Many of these banks use the single day method, in which the exposure is measured as being equal to all foreign exchange receipts that are due on the day. Some institutions use a multiple day approach for measuring risk. Most of the banks in EMEs use some form of individual counterparty limit to manage their exposures. These limits are often applied to the global operations of the institution. These limits are sometimes monitored by banks on a regular basis. In certain cases, there are separate limits for foreign exchange settlement exposures, while in other cases, limits for aggregate settlement exposures are created through a range of instruments. Bilateral obligation netting, in jurisdictions where it is legally certain, is an important way for trade counterparties to mitigate the foreign exchange settlement risk. This process allows trade counterparties to offset their gross settlement obligations to each other in the currencies they have traded and settle these obligations with the payment of a single net amount in each currency.

Several emerging markets in recent years have implemented domestic real time gross settlement (RTGS) systems for the settlement of high value and time critical payments to settle the domestic leg of foreign exchange transactions. Apart from risk reduction, these initiatives enable participants to actively manage the time at which they irrevocably pay way when selling the domestic currency, and reconcile final receipt when purchasing the domestic currency. Participants, therefore, are able to reduce the duration of the foreign exchange settlement risk.

Recognizing the systemic impact of foreign exchange settlement risk, an important element in the infrastructure for the efficient functioning of the Indian foreign exchange market has been the clearing and settlement of inter-bank USD-INR transactions. In pursuance of the recommendations of the Sodhani Committee, the Reserve Bank had set up the Clearing Corporation of India Ltd. (CCIL) in 2001 to mitigate risks in the Indian financial markets. The CCIL commenced settlement of foreign exchange operations for inter-bank USD-INR spot and forward trades from November 8, 2002 and for inter-bank USD-INR cash and tom trades from February 5, 2004. The CCIL undertakes settlement of foreign exchange trades on a multilateral net basis through a process of notation and all spot, cash and tom transactions are guaranteed for settlement from the trade date. Every eligible foreign exchange contract entered between members gets notated or replaced by two new contracts – between the CCIL and each of the two parties, respectively. Following the multilateral netting procedure, the net amount payable to, or receivable from, the CCIL in each currency is arrived at, member-wise. The Rupee leg is settled through the members’ current accounts with the Reserve Bank and the USD leg through CCIL’s account with the settlement bank at New York. The CCIL sets limits for each member bank on the basis of certain parameters such as member’s credit rating, net worth, asset value and management quality. The CCIL settled over 900,000 deals for a gross volume of US $ 1,180 billion in 2005-06. The CCIL has consistently endeavoured the entire gamut of foreign exchange transactions under its purview. Intermediation, by the CCIL thus, provides its members the benefits of risk mitigation, improved efficiency, lower operational cost and easier reconciliation of accounts with correspondents.

An issue related to the guaranteed settlement of transactions by the CCIL has been the extension of this facility to all forward trades as well. Member banks currently encounter problems in terms of huge outstanding foreign exchange exposures in their books and this comes in the way of their doing more trades in the market. Risks on such huge outstanding trades were found to be very high and so were the capital requirements for supporting such trades. Hence, many member banks have expressed their desire in several fora that the CCIL should extend its guarantee to these forward trades from the trade date itself which could lead to significant increase in the liquidity and depth in the forward market. The risks that banks today carry in their books on account of large outstanding forward positions will also be significantly reduced (Gopinath, 2005). This has also been one of the recommendations of the Committee on Fuller Capital Account Convertibility.

Apart from managing the foreign exchange settlement risk, participants also need to manage market risk, liquidity risk, credit risk and operational risk efficiently to avoid future losses. As per the guidelines framed by the Reserve Bank for banks to aligns and exposure in derivative markets as market makers, the boards of directors of ADs (category-I) are required to frame an appropriate policy and fix suitable limits for operations in the foreign exchange market. The net overnight open exchange position and the aggregate gap limits need to be approved by the Reserve Bank. The open position is generally measured separately for each foreign currency consisting of the net spot position, the net forward position, and the net options position. Various limits for exposure, viz., overnight, daylight, stop loss, gap limit, credit limit, value at risk (VaR), etc., for foreign exchange transactions by banks are fixed. Within the contour of these limits, front office of the treasury of ADs transacts in the foreign exchange market for customers and own proprietary requirements. These exposures are accounted, confirmed and settled by back office, while mid-office evaluates the profit and monitors adherence to risk limits on a continuous basis. In the case of market risk, most banks use a combination of measurement techniques including and managed by most banks on an aggregate counter-party basis so as to include all exposures in the underlying spot and derivative markets. Some banks also monitor country risk through cross-border country risk exposure limits. Liquidity risk is generally estimated by monitoring asset liability profile in various currencies in various buckets and monitoring currency-wise gaps in various buckets. Banks also track balances to be maintained on a daily basis in Nostro accounts, remittances and committed foreign currency term loans while monitoring liquidity risk.

To sum up, the foreign exchange market structure in India has undergone substantial transformation from the early 1990s. The market participants have become diversified and there are several instruments available to manage their risks. Sources of supply and demand in the foreign exchange market have also changed in line with the shifts in the relative importance in balance of payments from current to capital account. There has also been considerable improvement in the market infrastructure in terms of trading platforms and settlement mechanisms. Trading in Indian foreign exchange market is largely concentrated in the spot segment even as volumes in the derivatives segment are on the rise. Some of the issues that need attention to further improve the activity in the derivatives segment include flexibility in the use of various instruments, enhancing the knowledge and understanding the nature of risk involved in transacting the derivative products, reviewing the role of underlying in booking forward contracts and guaranteed settlements of forwards. Besides, market players would need to acquire the necessary expertise to use different kinds of instruments and manage the risks involved.