A tipping point in addressing FX settlement risks

The post-trade industry is transforming, and its evolution will be critical for accelerating the way the world moves value. Yet financial institutions face myriad challenges, including growing competition, new regulations and evolving customer expectations. Industry collaboration to connect ecosystems, set best practices and mutualise capabilities across businesses and value chains will be key in supporting the transformation journey.
Does the industry’s future lie in collaborative market platforms? Such platforms can offer the capital markets community mutualised post-trade services that are interoperable across geographies, business segments and multiple generations of back-office systems. Industry platforms should be scalable, transparent, and enable real-time, frictionless and secure financial transactions. This has the potential to help address one of the biggest challenges faced by participants in the FX industry: settlement risk. FX is an industry where more than $18 trillion is settled every day¹ from a variety of instruments covering more than 400 currency pairs and traded by thousands of financial firms over hundreds of different platforms. Rising volumes and complexity are bringing the question of FX settlement risk to the forefront for regulators, financial institutions and industry utilities.

From talk to action

The Basel Committee on Banking Supervision (BCBS) and the Committee on Payments and Market Infrastructures (CPMI) has urged bank supervisors to incorporate BCBS guidance on managing FX settlement risk into their supervisory frameworks and to assess whether banks are meeting that guidance.

In a letter² to supervisors, banks and other participants in the FX market, BCBS and CPMI recommended the use of payment versus payment (PvP) “where practicable” to eliminate principal risk in FX settlement. For FX transactions that do not settle via PvP, the guidance recommends that supervisors encourage banks to minimise the size and duration of their principal risk and to conduct timely reconciliation of payments received.

Other organisations have acknowledged the need for greater PvP adoption, including the Financial Stability Board³ and the Global Foreign Exchange Committee,⁴ which have both identified PvP as an important element in mitigating FX settlement risk.

In response to these moves, FX market settlement infrastructure CLS announced in September 2021 the piloting of a PvP settlement solution with 12 of its settlement members.⁵ Working in partnership with the public and private sector, CLS is working to develop a PvP solution that will address settlement risk for currencies that are not currently eligible for CLS settlement.

Managing settlement risk

Between 2016 and 2019, the trading of emerging market economy currencies outpaced that of major currencies, with global turnover rising 33% but the turnover of emerging market currencies rising by almost 60% to $1.6 trillion.⁶

While CLS currently removes around $5.5 trillion of settlement risk each day, according to BIS,⁷ this represents only one third of the total daily figure. The rising volumes of emerging market FX trades creates additional settlement risks that still has to be addressed by the industry.  

More than $10 trillion of settlement risk needs to be removed by other means. BIS also estimates that the proportion of trades with PvP protection appears to have fallen from 50% in 2013, to 40% in 2019. Whilst a small percentage would settle via cross-account movements for the ‘on-us’ settlement process or internal account movements for intra-group trades, a significant proportion will settle via payment instructions using the correspondent banking process. Whether settled gross or net, each party sends an outgoing payment and expects to receive an incoming payment. This is where FX settlement risk occurs – if the outgoing payment is sent but the incoming payment does not arrive, then there is a settlement failure.

While a PvP solution may take some years to come to fruition, in the meantime FX parties can use the SWIFT gpi service to reduce their settlement risk. The SWIFT gpi financial institution transfer service for MT 202⁸ provides full end-to-end transparency and tracking to high-value MT 202 payments messages. It enables users to monitor both the progress of a payment sent for the currency sold, as well as the incoming payment they expect for the currency bought.

SWIFT gpi has been tried and tested by a community of more than 4,200 financial institutions, which every day send the equivalent of $580 billion in value via gpi.

While not directly removing the risk, SWIFT gpi significantly improves the monitoring and management of FX settlement risk. Looking forward, this principle of linking the two payment legs together via SWIFT gpi could support new PvP-based solutions. For example, if implementing a solution based on an escrow account, funds could be unlocked with certainty following SWIFT gpi confirmation of credits for each payment leg. And, to support these new initiatives, SWIFT will continue to extend the transaction management and data capabilities of our platform. 

Using data to assess settlement exposure

There is also clearly a need for more industry data to understand how the 60% of those FX obligations without PvP protection settle. The good news is that valuable information on a significant percentage of the $6.6 trillion traded each day is now available.

Members of the SWIFT network can extract information from their own FX confirmations and view them as a dataset through SWIFT Watch Banking Analytics. Users can easily discover their daily counterparty exposure across all their branches, and across their counterparties’ branches too.
Privacy and access to these datasets is carefully managed, limiting SWIFT users to viewing their own data, and providing strict control to respect confidentiality and anonymity when viewing aggregated data at a market level.

A shifting paradigm

Digitisation and service innovation are key in today’s financial industry and SWIFT’s strategy to enable instant and frictionless transactions from account to account anywhere in the world reflects this. SWIFT is moving from a service based on sequential messaging to one focused on transaction management on a data-rich, collaborative platform that will give industry participants greater visibility and insights into their transactions.

By working together, SWIFT can provide the FX industry with a means to address the complex and significant challenge of FX settlement risk, while leveraging current and future investments and capabilities.