Measuring PvP success in addressing FX settlement risk and remaining challenges
Marc Bayle de Jessé explores the progress made by the FX industry in tackling settlement risk through the use of payment-versus-payment mechanisms and the challenges ahead.
Arguably, the most important success factor for the FX market is addressing the risk of loss of principal (or settlement risk) effectively. Payment-versus-payment (PvP) mechanisms like CLSSettlement have supported FX market growth by mitigating this risk for the currencies they settle, while also delivering substantial benefits such as liquidity optimization and operational efficiencies. CLS’s robust PvP settlement service has helped enable market growth, and FX turnover has multiplied by a factor of five since CLS went live in 2002.
As a result, CLSSettlement volumes have grown steadily with average daily values settled exceeding USD6.5 trillion in H12022. Much of this growth is from 30,000 indirect participants, including the buy side, that access CLSSettlement through its 70+ members, which comprise the world’s largest financial institutions.
Being a critical service provider to the FX market, CLS must be proportionately resilient to its key role as a global financial market infrastructure. CLS has a strong track record of service provision and has continued to invest heavily in cybersecurity, risk management and controls and its underlying technology to ensure it meets the highest levels of operational resilience.
In recent years, policymakers and regulators have renewed their focus on FX settlement risk. Specifically, they are concerned about sectors of the market where PvP is unavailable, particularly in emerging market (EM) currencies. CLS fully supports wider adoption of PvP and applauds the efforts of the Global Foreign Exchange Committee, whose FX Global Code encourages its use, as well as the Financial Stability Board’s Cross-Border Payments Roadmap, which has a dedicated building block to further PvP adoption.
“Addressing settlement risk effectively has been largely achieved for CLS-eligible currencies”
To better understand settlement risk, CLS, in collaboration with its members, analysed multiple member banks’ trades to determine how they were settled, to provide a good indication of the market’s management of settlement risk and the range of mechanisms used to settle FX flows.
The analysis showed that of the FX transactions eligible for CLSSettlement (which comprise 80% of all FX transactions)1, on average 51% of the traded notional is settled through CLSSettlement, while much of the remainder comprises inter-branch and inter-affiliate trades (35%) or trades where settlement occurs via a single currency cashflow or over accounts within the banks’ direct control (together, 8%). This leaves around 6% of trades exposed to settlement risk that could be settled via PvP in CLSSettlement, primarily comprising smaller trades across multiple corporates and funds that do not trade high volume.
CLS’s findings are complementary to – but not directly comparable to – the BIS Survey, which showed that the share of FX transactions settled without PvP is one fifth of the market (including the 6% mentioned). The BIS Survey scope is wider and includes both CLS-eligible and -ineligible currencies, EM currencies in the main that have seen significantly increased trading volumes in recent years.
The 6% that could be settled via PvP is the target of CLS’s efforts to increase adoption of CLSSettlement. Addressing settlement risk beyond CLS-eligible currencies may require an alternative solution. Given its systemic importance, adding new currencies to CLSSettlement is an extended effort that is subject to several requirements, including ongoing support from the central banks on both sides of the currency flow and in some cases changes in the target jurisdiction’s laws and regulations.
Given these complexities, CLS is exploring several avenues to expand PvP coverage, including a possible new PvP service for certain currencies. However, geopolitical factors have led CLS to reassess the pace at which this moves forward. For now, CLS is focusing on growing CLSNet, its automated bilateral payment netting calculation service for over 120 currencies.
CLSNet already helps to mitigate operational risk associated with trading EM currencies. It supports netting to reduce the payment obligations exposed to settlement risk while improving operational and liquidity efficiencies. The majority of the interbank transaction flow through CLSNet is in the deliverable EM currencies that pose the most settlement risk for CLS’s members. As a result, the flows in CLSNet increased exponentially over the course of 2022 and have continued to increase in 2023.
Successful settlement risk mitigation has been largely achieved for CLS-eligible currencies. But with the growth in EM currency trading, the remaining challenge is how to achieve settlement risk mitigation for currencies ineligible for PvP settlement. For these currencies, until a new PvP solution can be developed, mitigating operational risk, optimizing liquidity and creating operational efficiencies through a centralized, standardized and automated process, like CLSNet, is the industry’s preferred approach.
First published in “Views – The EuroFi magazine”, April 2023
1. 2022 BIS Triennial Central Bank Survey of FX and OTC derivatives markets (BIS Survey).
