Herstatt risk is not dead - or - nyah nyah we've got your yen
Back in the seventies, a German bank named Herstatt Bank earned an ignominious place in history. It opened for business one sunny summer’s day, and halfway through the day, it settled some of its outstanding FX transactions by taking in a whole bunch of Deutschmarks - the idea being that later in the day, when its US clearing bank opened for business, it would pay out the US dollars that were on the opposite side of those dollar-mark trades.
But before banks started to open that morning in the States, Herstatt Bank collapsed, and was placed into liquidation by the German government.
So the banks that had traded dollar-mark with Herstatt had delivered the marks that they’d sold, but would never receive the dollars that they’d bought - so they were out the whole gross value (potentially multiple millions of dollars) of their FX trades with Herstatt.
This risk - the risk that a bank will deliver something that it’s sold, and not get anything back in return - has ever since then been known as Herstatt risk.
And because losing hundreds of millions of dollars can totally ruin your breakfast, a bunch of banks got together and created a system called Continuous Linked Settlement. Instead of waiting for the payment systems in each country to open and making payments asynchronously, CLS allows “payment-versus-payment” settlement, where every bank gets the money it’s owed at the same instant it pays out. So - no chance for a bank to fail to deliver, and no Herstatt risk. (Here’s an article from CLS Bank, the overseer of the CLS process, that explains the process in a bit more detail.)
Nowadays, everyone settles everything via CLS, and Herstatt risk should never be an issue. Right?
Unsettled Foreign Exchange Transaction with Icelandic Banks
Last year, ACI - The Financial Markets Association was approached by an international bank concerning an unsettled foreign exchange transaction with an Icelandic bank.
What was the story? The international bank had entered into a simple foreign exchange swap whereby the parties agreed to purchase and to sell US-dollars versus Japanese yen at two different value dates in September and October 2008. The first half of this transaction proceeded as agreed in September 2008. Under the parties’ agreement the international bank was obliged to deliver USD to the Icelandic counterparty in early October 2008. In exchange the Icelandic bank had to pay the same day the agreed countervalue in JPY. The international bank was to deliver the US funds to the Icelandic bank’s correspondent account with a New York-based clearer, while the Icelandic bank was to deliver the JPY payment to the international bank through a Japanese clearer in Tokyo.
So far, so good. FX swaps happen - and in USDJPY, they happen in size.
On October 6, Iceland enacted Act No 125⁄2008 authorising its Financial Supervisory Authority (the “FME”) to take over the operations of an Icelandic bank if it was unable to meet its obligations. On October 7 the Icelandic bank involved issued a press release entitled “no Indication of Government Intervention” in which it stated “our bank has not been approached by the Icelandic FME regarding any intervention in the Icelandic bank’s operations.”
Incidentally, five seconds’ Googling reveals that the Icelandic bank is (was?) Kaupthing. Carry on…
The international bank finally learnt the next morning that the Icelandic bank had been placed into receivership and had failed to settle the JPY payment under the FX trade until after the international bank had transferred its funds to be paid to the US clearer of the Icelandic bank.
Again in October the US clearer asked the Icelandic bank to return the paid funds, but some days later the same month the US clearer advised the international bank that “return of funds was not authorised by the committee appointed by the FME”.
“Your yen has disappeared. It is an ex-yen. It has ceased to be.” Did they chuck it into the volcano or something?
And, unsurprisingly, ACI is not impressed by Kaupthing’s “nyah nyah nyah we’ve got your money” behaviour…
_Up to the point of writing ACI has been contacted by three international banks and asked for assistance and help with unsettled foreign exchange transactions with Icelandic banks. ACI - The Financial Markets Association considers this behaviour as a clear breach of all international rules and, of course, of the best market practices governed by its Model Code. ACI’s Executive Board established contact with the Iceland Ministry of Finance, the Central Bank of Iceland, an Iceland Resolution Committee, the European Commission, as well as the Institute of International Finance._
The cases are still open and ACI will report on further developments.