Forex Blog: Currency Trading News & Analysis.

April 27th 2010

No Credit Risk in Forex

The risks in trading forex are manifold. There is interest rate risk (the possibility that interest rates could change adversely), country risk (that a political, economic, or monetary crisis could adversely affect the dynamics of a country’s currency), and obviously there is exchange rate risk (that exchange rates can and often do fluctuate adversely). However, there is zero or nil credit risk. Why is that?!

First of all, what do I mean by credit risk? Often used interchangeably with the terms settlement risk and counterparty risk (depending on the type of security/investment in question), credit risk refers to the possibility that one party (all financial transactions necessarily involve two parties) will not honor its side of the financial agreement. In the case of forex, this refers to the risk that either the buyer or the seller will not be able to fulfill its promise to deliver currency at the agreed-upon exchange rate. For example, let’s assume that I’ve signed a contract to exchange $100 Dollars for Euros at $1.35. There is a risk that after you hand over the Dollars, the counterparty will not be able to supply the Euros, and even worse, that it won’t be able to return your Dollars.

With regard to transactions involving other types of securities (especially derivatives), this risk is very real, albeit minimal. Anyone who signed a long-term financial contract with Lehman Brothers or Bear Stearns is probably fighting in bankruptcy court to collect pennies on every dollar that they are owed. As I said, however, this is essentially a non-risk in forex. While currency markets fluctuated wildly in the wake of both bankruptcies, these fluctuations were completed unrelated to the possibility that Lehman Brothers and Bear Stearns would not be able to honor their trades, and in fact forex markets continued functioning with very little interruption. In fact, “In the dreadful week following Lehman Brothers’ collapse, more than $150bn of Lehman’s FX trades were settled successfully.” How was this possible?

The answer is CLS, or Continuous Linked Settlement, which is an interconnected system used exclusively for settling foreign exchange transactions, and owned by its member banks. CLS handles 55% of all forex transactions (but a much higher proportion of the volume), amounting to Trillions of dollars in activity per day, and involving 17 of the most popular currencies. Basically, all trades involving major financial institutions (7,000 at last count) pass through CLS, and are netted out at the end of each day such that each participating bank only has to make and receive payment once (for each currency) rather than 10,000 separate times.

As far as retail forex trading is concerned, this doesn’t mean that every trade that you make passes through CLS or even that your broker is itself a member of CLS (chances are that it isn’t). Instead, your broker probably settles all of these trades internally, and then must settle with its market makers at the end of each day, who in turn, settle with each other through CLS. Even though you aren’t directly connected with CLS, its existence still makes seamless forex trading possible for you.

At the same time, CLS doesn’t do anything to limit the possibility that your broker will go bankrupt (like Lehman Brothers), and that you won’t have to line up outside of bankruptcy court to try to reclaim the balance of your account. (Still, this is unlikely if you’ve selected a reputable broker with a healthy capital position). Instead, it means that when you place 100 trades over the course of a day, you can now take for granted the fact that all of them will be settled on time at the correct exchange rate.

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Posted by Adam Kritzer | in Investing & Trading, News | 1 Comment »

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One Review of “No Credit Risk in Forex”

  1. George Webster Says:

    That’s why I love trading foreign currency. When scandals abound in the stock market and financial sector, Forex still holds strong.

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