The Reserve Bank of India introduced a new settlement system in May 2005 to mitigate risks in payment systems. The Central Bank intends to rationalize clearing operations by setting up new clearing houses. The author brings out the features of new settlement system and its impact on risk reduction.

US dollar is the major currency in which most of the India's export and import transactions are invoiced. It is also the currency in which most of the inward remittances are received in India. As a result, the domestic interbank market in foreign currency in India is mostly confined to buying and selling US dollar against Indian rupee. This market is an Over the Counter market (OTC market) which has experienced phenomenal growth in the volume of transactions during the last one and a half decade. Increase in the size of market has also brought in significant liquidity. Over the years, the market has also matured and it now offers relatively sophisticated products like Indian rupee/US dollar currency swaps, and currency options, to name a few.

Domestic market in Indian rupee closes before the US dollar market becomes active. Settlement in Indian rupee funds for any Indian rupee/US dollar trade, therefore, happens before settlement of US dollar funds i.e., the settlement is not on Payment versus Payment (PVP) basis. A trader who buys US dollar against Indian rupee can therefore loose the entire amount if the counterparty fails to pay US dollar after receiving Indian rupee. The counterparty exposure is therefore a major cause of concern for participants in this market.

Increase in the size of the market over the years has been causing increase of counterparty exposures of the market participants. Possible consequences of a default by any market participant has also been increasing correspondingly. Moreover, with the increase in trade volume, settlement cost has also been mounting. To reduce the risk from any possible failed settlement, banks started changing their settlements from deal-wise settlements to settlements on net-basis with their counterparties (i.e. through bilateral netting). This resulted in risk reduction to an extent but the remaining risk continued to remain high. Cost of transactions also remained high.

Treasury Management Journal, Settlement System, Domestic Foreign Exchange Market, OTC Markets, Domestic Markets, Clearing Corporation of India Ltd., CCIL, Derivatives Market, Risk Management, Indian Financial System, Domestic Foreign Exchange Markets, ABN AMRO Bank, Market Risk, Continuous Linked Settlement, Risk Management Systems, European Central Bank, Reserve Bank of India, RBI.