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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.