Credit risk

Settlement risk arises in transactions involving exchange of value when we must honor our obligation to deliver without first being able to determine that we have received the counter-value. Market volumes have continued to rise year on year. We have expanded our own transaction volume without increasing settlement risk by the same proportion, through the use of multilateral and bilateral arrangements, and in fourth quarter 2006, settlement exposure was reduced to 22% of gross volumes.

The most significant portion of our settlement risk exposure arises from foreign exchange transactions. Our membership in CLS (Continuous Linked Settlement), a foreign exchange clearing house which allows transactions to be settled on a delivery versus payment basis, has significantly reduced our foreign exchange-related settlement risk relative to the volume of our business. In 2006, the transaction volume settled through CLS continued to increase, although the proportion of our overall gross settlement volumes settled through CLS fell to 55% in fourth quarter 2006 from 59% in fourth quarter 2005. Of our CLS volume, 72% was with other CLS Settlement Members and the remainder with so-called Third Party Members, who settle their eligible trades via CLS Settlement Members. While the number of CLS Settlement Members is relatively stable, in 2006 the number of Third Party Members we deal with has again increased considerably.

Risk reduction by other means – primarily account-account settlement and payment netting – increased to 23% of gross volumes in fourth quarter 2006 from 17% a year earlier.

The avoidance of settlement risk through CLS and other means does not, of course, eliminate the credit risk on foreign exchange transactions resulting from changes in exchange rates prior to settlement. We measure and control this pre-settlement risk on forward foreign exchange transactions as part of the overall credit risk on OTC derivatives, as described under "Credit risk control".