Economics Update (July-September 1997)

Are International Settlements a New
Source of Systemic Risk?

O ne positive result of economic expansion and technological change is that global markets are becoming increasingly integrated. Ironically, though, internationalization also contributes to a less-desired segmentation of markets, as Atlanta Fed Senior Vice President and Director of Research Robert A. Eisenbeis explains in an article in the Atlanta Fed's Second Quarter 1997 Economic Review.

Eisenbeis describes how internationalization has affected settlements in the financial market. Globalization, he says, has not created new risks for the market but has instead provided opportunities for the emergence of new elements of systemic risk. Differences in institutional regulations, government laws and time zones from country to country complicate world financial markets and are in part responsible for the losses and distributional problems that sometimes emerge when cross-border transactions are performed.

Eisenbeis cites netting systems as settlement forms that can contribute to uncertainty. Netting involves gathering all debts and credits for a transaction and transferring their difference at a set time. On an international level, netting can create problems when time differences exist and when settlement regulations vary from one government or institution to another.

For example, in cases of currency exchange between banks in different countries, one bank may complete its portion of a transaction, but differences in bank closing times and time zones may prevent the other bank from settling its side of the exchange. As a result, the two banks may have misconceptions about available funds. Such misconceptions can lead to large financial losses and create a type of systemic risk called Herstatt risk, in reference to the German Herstatt Bank, which failed under such circumstances in 1974.

According to Eisenbeis, "In international settlements, final disposition of the liability depends critically on the legal rules governing the disposition of debts and transactions in the event of a default or bankruptcy. Since the legal rules may differ according to where the settlement takes place, and this location may be beyond the receiver's control, settlement uncertainty exists."

While netting systems have the advantage of being efficient, there are practical difficulties involved in changing laws and regulations and enhancing cooperation and communication on an international scale to reduce the risks inherent in netting arrangements. These difficulties are pushing payments systems toward alternative settlement methods; the most prevalent of these is real-time gross settlement (RTGS).

Under an RTGS system, individual transactions are processed as they are received, limiting the duration of both credit and liquidity risks. The Federal Reserve's Fedwire is one example of an existing RTGS system.

Many European countries have already adopted or plan to adopt RTGS systems. In fact, one of the criteria for admission to the European Union is that countries have RTGS systems in place. The European Union's umbrella settlement system, Target, which will link settlement systems within the union, is designed as an RTGS system.

As financial markets continue to expand and evolve, Eisenbeis concludes, it is becoming increasingly important that all payments systems find practical ways, such as RTGS, to decrease risk uncertainty.

Return to Index