It is of essential importance in operation of all banks to explore the time duration for the transaction realization and the time period during which the bank is at risk in relation with non-realization of a contract for signed transactions. Each bank has to specify two deadlines: deadline until which the bank may unilaterally make annulment of payment orders and deadline in which it is established if the settlement was realized as per all contractual terms or the settlement was not executed in that manner.
Deadline in which the bank may annul its order may be defined as ultimate time in all regular and ordinary situations; the bank may one-sidedly change the payment order or send the instructions with delay. For example, if the bank uses correspondent bank in order to meet its part of the agreement, this deadline is the time until when a correction order may be sent to its correspondent bank, before the correspondent bank may initiate its realization.
Second deadline or the time which is established if the settlement was completed as agreed, is named as the time which starts at the moment agreed for settlement with the contracting party, and ends at the moment when the bank is safe that the settlement was realized within the anticipated time and the projected amount or some omission was made in the settlement. For example, if the bank uses correspondent bank for receipt of payment orders, this time is the time when the bank checks up the information it gets from its correspondent bank and verifies if everything is in order.
With the traditional manner of work, settlement with it brings high operational, liquidity risk, which is identical with the value of the agreed transactions. Each party is exposed to these risks, because it may fear at any moment that the counter party shall meet its liabilities.
Risk exposure starts at the moment when the contract is signed, i.e. at the moment when it is no longer possible to return the assets already paid out. Risk exposure terminates at the moment when the entire transaction is completed. Although the transaction is completed with the ending of the period and with the completion of the financial transactions by the both contracting parties, still the entire process is not completed until the moment when the both contracting parties make audit over the entire process and establish if everything was as expected.
For example, bank A has signed spot contract with the bank B, where it sells Japanese Yens for USD. Contract is signed T+2.
Aiming to fulfill its liabilities, the bank A sends instructions to its correspondent bank in Japan, with plead to send certain amount of Yens to bank B, at the settlement day T+2. Japanese correspondent bank executes the instructions received by bank A, by indebting the account which bank A has with the Japanese bank and transfers the Yens to the bank B (via correspondent bank of the bank B in Japan) through a relevant payment system.
At the same time, the bank B is settling its side of the contract in identical process, by giving instructions to its correspondent bank in USA for transfer of USD dollars to the correspondent bank of the bank A in USA.
Seen from the point of view of the bank A, risk exposure begins at the moment when it sends its transfer instructions for financial assets to its correspondent bank in Japan in order to transfer Yens to bank B. In absence of a different agreement from the standard one, bank A may transfer the requested funds at any time of day T+2. Latest deadline for recall of the given transactions is the moment of start up of the working hours of the bank A, i.e. the Japanese payment system. Until that moment, the bank A has a possibility to recall its payment order instruction.
Risk exposure for bank A terminates at the moment when the requested financial assets (the USD) appear at the account of its correspondent bank in USA. The correspondent bank in USA may not receive the expected financial assets at the due date.
Bank B is in same situation. This bank also, by using the traditional manner of settlement, faces operational and financial risk.
In the previously analyzed case, the time difference and the risk resulting from the time difference, falls on bank A. Because it is selling currency in a country in which the time zone is more favorable that the USA time zone. Day T+2 starts in the American institution when the T+2 ends with the Japanese institutions.
There are two time periods of risk time duration. Risk that lasts from the moment of signing the contract, till the due time known as Irrevocable risk (Risk I) and risk which exists until the audit is completed if everything has ended well known as Uncertain risk (Risk U). It is necessary to synchronize these two types of risks and make good analysis, predominantly for the rating of the business partner, in order to avoid this risk.