Settlement risk: addressing the key issue in cross-border payments
Marc Bayle de Jessé discusses how the FX industry is working together to address the issue of increasing settlement risk in cross-border payments.
Cross-border payments by their very nature involve the settlement of an FX transaction which requires payment of one currency for receipt of another. One of the main risks in such transactions – settlement risk – is the risk that one party delivers the currency it sold but does not receive the currency it bought from its counterparty, resulting in a loss of principal. Such a loss of principal may be manageable if the amount is small. However, today’s global FX market is anything but small – it is the largest financial market in the world with an average daily volume of USD6.6 trillion.1
There is evidence that FX settlement risk is on the rise and may be reaching levels that threaten global financial stability. In recent years there has been an increase in global trading of currencies that do not have access to payment-versus-payment (PvP) settlement mechanisms like CLSSettlement. This has resulted in a heightened focus on overall risk management in cross-border payments, with both the public sector and market participants expressing particular concern about rising settlement risk and calling for greater adoption of PvP mechanisms as the optimum solution to mitigate FX settlement risk.
To better understand settlement risk for currencies that are not currently eligible for CLSSettlement and how FX trades are settled in those currencies, CLS is working with its global settlement members to analyze their settlement activity. It is expected that the results will provide further transparency on settlement behavior in the FX market and enable CLS to contribute useful findings and conclusions towards a range of key policy initiatives.
To address the issue of PvP adoption more widely and deliver improvements to cross-border payments, collaboration between the public and private sectors is essential. Through two public policy initiatives, in consultation with the private sector, the industry is making great strides in addressing the issue of settlement risk in cross-border payments.
“A strong public-private partnership is required to build a successful cross-border solution to remove FX settlement risk from global financial markets.”
The first is the Committee on Payments and Market Infrastructure’s (CPMI) request for industry input on improvements to existing payment infrastructures and arrangements to enhance cross-border payments. This led to a recent policy initiative to encourage PvP adoption in the FX market through the inclusion of building block 9 of the Financial Stability Board’s (FSB) “Enhancing Cross-Border Payments Stage 3” roadmap.
The second is the three-year review of the FX Global Code undertaken by the Global Foreign Exchange Committee (GFXC).2 The updated version of the Code includes amendments to the key principles concerning settlement risk, principles 35 and 50 – placing greater emphasis on the use of PvP settlement mechanisms where available, and providing more detailed guidance on the management of settlement risk where PvP settlement is not used. The changes to the Code will encourage FX market participants to explore ways to mitigate risk further and reduce operational costs by adopting a best practice approach to FX settlement risk management and netting.
In response to the need to increase PvP settlement in currencies that are not currently eligible for CLSSettlement, CLS has established a working group to evaluate market demand and explore potential alternative PvP solutions. Initial feedback shows a strong interest in a new PvP solution, and as a result, an industry pilot is underway which will evaluate the liquidity and settlement risk of potential models. In addition, CLS is considering the benefits of each solution in view of certain factors such as account structure, legal framework, and local market practices and regulations. While this initiative has considerable industry support and momentum behind it – twelve of CLS’s settlement members have formed the working group – any new Financial Market Infrastructure (FMI) solution must prioritize safety, stability, and scalability. Hence, any alternative PvP solution will require ample time for appropriate implementation.
For an FMI like CLS to deliver an optimal solution to public policy and industry challenges such as wider settlement risk mitigation, it must invest heavily in its products, risk management and controls and respective underlying technology on an ongoing basis. This is one of the key drivers behind the completion of a significant phase in CLS’s multi-year technology investment program, known as Convergence. CLS recently completed a significant phase of this initiative by migrating CLSSettlement onto its Unified Services Platform (USP), thereby optimizing the underlying technology platform supporting its settlement services. As a result, CLS now has one of the most sophisticated, resilient, scalable, and flexible post-trade technology platforms across global FMIs, which will enable the organization to evolve its PvP offering more easily to the requirements of the FX market.
The implementation of best practices related to mitigating settlement risk and efficient post- trade practices in the FX markets is a high priority for market participants, policymakers, and regulators. As a systemically important financial market infrastructure that operates a settlement system for FX transactions (CLSSettlement), CLS supports the industry objectives regarding mitigating settlement risk, and it is committed to raising awareness of PvP adoption more broadly.
In order to develop the optimal model to solve these industry challenges, policy makers and the private sector should, and are, engaging with market participants on an ongoing basis. This approach is crucial to ensuring the market’s needs are truly understood and that the preferred solution obtains sufficient industry investment and support. In short, a strong public-private partnership – similar to the one that created CLS in 2002 – is required to build a successful cross-border solution to remove FX settlement risk from global financial markets.
First published in “Views – The EuroFi magazine”, September 2021
1. Bank for International Settlements. "Foreign Exchange Turnover in April 2019."
2. The Global Foreign Exchange Committee endorsed the outcomes of the Code review on 28 June 2021
