Cross currency settlement refers to a transaction or cross currency pair that does not use the U.S. dollar. In an international foreign exchange market, also known as a spot market, buying and selling foreign currencies means that there will be two currencies involved in the transaction. Therefore, currencies are traded in pairs.
An example of a description for a currency pair can be CAD/GBP or EUR/JPY. In each pair, the first currency is referred to as the transaction currency, and the second currency in the pair is known to be the settlement currency. In particular, a cross currency pair refers to a currency pair that does not use the U.S. dollar for either the transaction currency or the settlement currency.
How Does Cross Currency Settlement Work?
The transaction currency is the currency that you will be purchasing and selling in a foreign exchange market. If there are any gains or losses pertaining to the foreign exchange transaction, it is applied to the settlement currency.
When the amount of transaction currency is multiplied by the foreign exchange rate between the two currencies, it will give the amount of settlement currency that should be used in the transaction.
For example, an investor wants to purchase 1,000 euros with Japanese yen. The exchange rate between these two currencies is 1 EUR to 130 JPY. Here, euros would be the transaction currency, and the Japanese yen would be the settlement currency. As a result, the amount for the settlement currency (yen) is 1,000 EUR x 130 JPY = 130,000 JPY.
What is Cross Currency Settlement Risk?
There are risks involved when cross currency settlements take place – referred to as cross currency settlement risk. It is a type of settlement risk that occurs in a foreign exchange settlement where one of the parties of the transaction would send the currency that they sold, but they do not receive the currency that they bought.
As a result, the foreign currency transaction is not complete, and the entire amount that is purchased is at risk of loss. Settlement risk refers to the possibility that one or more of the parties do not carry out simultaneously the terms of the contract or transaction that all the parties agreed on.
For cross currency settlement, one of the reasons for risk to occur is due to the difference in time zones across the world. When foreign currencies are involved in a transaction, these currencies usually come from countries that belong to different time zones. As a result, the foreign exchange transaction may not be settled at the same time due to time differences.
Example of Cross Currency Settlement Risk
For example, cross currency settlement risk may occur when a bank in France purchases 5 million Canadian dollars in a foreign exchange market.
Suppose the foreign exchange rate between the two currencies is 0.65 EUR to 1 CAD. At settlement, the bank in France would pay out 3.25 million EUR (5 million CAD x 0.65 EUR) in exchange for 5 million CAD.
Cross currency settlement risk can occur if the French bank makes a payment to the Canadian bank a few hours before the latter provides the 5 million CAD that the bank in France purchased.
CFI offers the Capital Markets & Securities Analyst (CMSA)® certification program for those looking to take their careers to the next level. To keep learning and advance your career, the following resources will be helpful: