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Continued from page 2

"BANK FRAUD UP A NOTCH OR WAS IT JUST A MISTAKE?"

NOBODIES PERFECT, YOU KNOW

A more complex problem occurred in 1974, a year in which foreign exchange contracts were literally less than one percent of the volume we see today. On June 26 of that year at approximately 11:00 am Eastern Standard time, Bankhaus ID Herstatt KGaA was closed, a penalty imposed on it primarily for consistently guessing wrong while speculating on currency movements ( ). Being unaware of the closing and having outstanding foreign exchange transactions to settle, payments were made and when it was found that Herstatt was already out of business, fruitless attempts to unwind the transactions were made, both at the central bank and judicial levels, to no avail. The ruling, once the transactions became part of the system, they no longer were the property of the issuing parties. This problem caused a twenty-car pileup, as overdrafts became systemic and financial gridlock appeared the order of the day. The entire German banking system reverberated and nearly fell from fallout brought on by this inconsequential financial institution. The simplest solution would have been one of retrenchment until the smog had left the battlefield: tightly shield one's collateral and "fail" on settlements, until it was clear who was left on the playing field. Cooler heads would have prevailed and cooperation between club members would have prevented a system wide collapse. As it was, chaos reigned supreme.

Bankhaus Herstatt failed to deliver US dollars to counterparties after it was ordered into liquidation by the German authorities in 1974. On June 26, 1974, at approximately 11:00 am Eastern Standard time, Bankhaus ID Herstatt KGaA was closed, and a penalty was imposed on it primarily for consistently guessing wrong while speculating on currency movements Being unaware of the closing and having outstanding foreign exchange transactions to settle, payments were made. When it was found that Herstatt was already out of business, fruitless attempts were made to unwind its currency transactions, both at the central bank and judicial levels, to no avail. The ruling: once the transactions became part of the system, they were no longer the property of the issuing parties. A new phrase crept in the language, the "Herstatt risk", the potential that a bank will deliver currency on one side of a foreign-exchange transaction, without receiving recompense on the other.

Banks are exposed to large amounts of cross-border settlement risk because irrevocable settlement of the separate legs of a foreign exchange transaction may be made at different times. For example, delivery of yen to a New York bank's Japanese correspondent bank in Tokyo occurs during Tokyo business hours, while the corresponding delivery of dollars by a New York bank to a Japanese counterparty's US correspondent bank in New York occurs during New York business hours. Since the two national payment systems are never open at the same time, there is the risk that after the first counterparty has delivered one side of the transaction, the other counterparty may go bankrupt and fail to deliver the offsetting currency.

More than 20 years after the collapse of Herstatt, there is still no widely accepted method of quantifying settlement risk. The Foreign Exchange Committee, a private sector group sponsored by the Federal Reserve Bank of New York, was the first to survey foreign exchange dealers and provide a methodology for examining settlement risk, as well as a set of recommended best practices, in its report, "Reducing Foreign Exchange Settlement Risk." More recently, in March 1996, the Committee on Payment and Settlement Systems of the Group of Ten (the ten industrial countries with the largest economies) released the Allsopp Report, which, building on the earlier methodology, analyzes existing arrangements and sets out a strategy for reducing settlement risk.

TIMING IS EVERYTHING

"The Allsopp Report found that foreign exchange settlement is not just an intra-day phenomenon and that payment lags can initially last at least one to two business days; another one to two business days may then elapse before a bank is assured that it has received the requisite payments. The amount at risk at a bank could exceed three days' worth of trades, so that the exposure to even a single counterparty could exceed a bank's capital. While the risk is only beginning to be recognized and quantified, recent foreign exchange payment defaults, including those of the Bank of Credit and Commerce International (BCCI) and Barings Plc, demonstrate that the risk cannot be ignored." (Laura E. Kodres, International Capital Markets, IMF)

IF YOU DIDN'T UNDERSTAND THE DERIVATIVE WORKS HOW ARE YOU GOING TO MAKE OUT WITH THE REPO?

The investment industry works pretty much like any other business when you really get down to it. Orders come; they are executed, and then sent to the operations people for fulfillment. Being that so much money can be involved, the small firms have the larger ones take on that responsibility (clearing firms) and effectively guarantee their existence, as well. As an example, if I called you and said I wanted to buy $100 million of Government securities and told you that I was Drysdale, you would probably say "who", just before hanging up the phone. If, on the other hand, I called and said that I was Drysdale Securities and I want to buy $100 million of Government securities and make the delivery against payment to my clearing firm, Chase Manhattan, you would say, "when do you want them?" That is really the essence of how the "street" functions; the big boys clear for the little guys and usually make a lot of money doing it.

There really is a Chase Manhattan Bank, and believe it or not, there really was a Drysdale. Drysdale Government Securities was a minor bond dealer that used some very esoteric strategies that just worked fine on paper. In practice, they were never able to get it right and they went down the drain May 17, 1982.

It seems that Drysdale didn't really have any money, but had borrowed over $2 billion to see if they could make it work. It didn't, and Chase, along with two other banks in for much smaller amounts, Manufacturers Hanover and United States Trust, were in the soup. Chase did what every other red blooded American bank would have done under the circumstances, they panicked and announced the unthinkable, they were not responsible. Understand, the street had operated in this fashion since the New York Stock Exchange had opened its doors and the rules had always remained the same. And worse, if Chase could walk away from a legal debt, then so could everyone else. Simply put, the system would fall into the East River of New York.

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