Settlement 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. The most significant portion of our settlement risk exposure arises from foreign exchange transactions. Through our membership of Continuous Linked Settlement (CLS), a clearing house for foreign exchange settlement which allows transactions to be settled on a delivery versus payment basis, we have significantly reduced our foreign exchange related settlement risk relative to the volume of our business. In 2005, the transaction volume settled through CLS continued to increase in absolute terms and reached 59% of overall gross volumes by fourth quarter 2005, compared to 57% in fourth quarter 2004. 76% of the CLS volume 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, the number of Third Party Members we deal with has again nearly doubled during 2005. Overall market growth has also been significant but CLS has allowed us to increase our own volumes without our settlement risk increasing by the same proportion.

CLS 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 traded products, as described on page 58–59, Limits and controls.