By Marc Bayle de Jessé,  CEO, CLS
By Marc Bayle de Jessé, CEO, CLS

The FX Global Code: Championing global standards and best practices in FX settlement risk mitigation

There has been a clear trend in FX markets in recent years: the rise in global trading of currencies that do not have payment-versus-payment (PvP) settlement mechanisms, many of them from emerging markets.

There has been a clear trend in FX markets in recent years: the rise in global trading of currencies that do not have payment-versus-payment (PvP) settlement mechanisms, many of them from emerging markets. At the same time, the FX community recognizes that it must continue to push for resilience, standardization, ease of access and interoperability across financial market infrastructure solutions. 

The FX Global Code – settlement risk principles

Principle 35: Market participants should reduce their settlement risk as much as practicable, including by settling FX transactions through services that provide PvP settlement where available. Whenever practicable, market participants should eliminate settlement risk by using settlement services that provide PvP settlement. Where PvP settlement is not used, market participants should reduce the size and duration of their settlement risk as much as practicable. The netting of FX settlement obligations (including the use of automated settlement netting systems) is encouraged. 

Principle 50: Market participants should properly measure, monitor and control their settlement risk equivalently to other counterparty credit exposures of similar size and duration. Where PvP settlement is not used, settlement risk should be properly measured, monitored and controlled. Market participants should set binding ex ante limits and use controls equivalent to other credit exposures of similar size and duration to the same counterparty.

In parallel with this heightened focus on overall risk management, public and private side participants have become particularly concerned about rising settlement risk. As a result, the public sector and market participants have been calling for greater adoption of PvP settlement in the FX market. One of these initiatives is from the Global Foreign Exchange Committee (GFXC), which recently published an updated version of the FX Global Code following its three-year review1. In particular, we wholly support the amendments to the settlement risk principles, which rightly place greater emphasis on the use of PvP settlement mechanisms, where available. We also welcome the language promoting the netting of settlement obligations, should PvP settlement mechanisms not be available.

PvP settlement, offered by CLSSettlement, is the most effective way to mitigate FX settlement risk as it enables both sides of an FX trade to be settled simultaneously, eliminating the risk that would exist if one party to the trade delivers the currency sold but does not receive the currency it bought from its counterparty. Without PvP, counterparties must rely on non-PvP settlement arrangements such as bilateral gross settlement which may leave counterparties exposed to significant settlement risk.  

For currencies that are not currently eligible for PvP protection, which include many emerging market currencies, the netting of FX payments, particularly if conducted via an automated netting system, can provide significant risk mitigation and efficiency benefits. 

“We wholly support the amendments to the settlement risk principles, which rightly place greater emphasis on the use of PvP settlement mechanisms, where available.”

 

By using a bilateral payment netting calculation service for FX trades, such as CLSNet, market participants can calculate net payment amounts directly with full automation in a standardized central process with their counterparties before settling through the correspondent banking system. At present, many market participants manage bilateral netting calculations and agreements via email and phone which is fraught with the operational risk associated with these manual processes.
In addition to the recent changes to the FX Global Code, there are other public policy initiatives to encourage PvP adoption in the FX market. The inclusion of building block 9, “Facilitating increased adoption of PvP” and related action items in the Financial Stability Board’s/CPMI’s Cross Border Payments Roadmap is another good example of this. 

Other initiatives are focused on obtaining a clearer understanding of the true scope of FX settlement risk in global financial markets, such as the potential inclusion of questions about settlement practices in the FX turnover surveys conducted by local FX Committees. Meanwhile, the Bank for International Settlements has requested more granularity in the information on FX settlement practices for its 2022 Triennial Central Bank Survey of Foreign Exchange and OTC Derivatives Markets, and recently published reporting guidelines2.

“To address the issue of mitigating settlement risk for currencies not supported by CLSSettlement, we are working with our settlement members to evaluate market demand and the viability of potential PvP solutions.”

With this in mind, CLS is leading a detailed data analysis with a group of global settlement members to better understand settlement risk for currencies that are not currently eligible for CLSSettlement and how FX trades are settled in those currencies. The initiative is due to be completed during 2021 and will enable us to validate findings, produce aggregated, anonymized data points, and contribute the combined findings and conclusions towards a range of key policy initiatives as the results should provide better data on settlement practices. 

Further and to address the issue of mitigating settlement risk for currencies not supported by CLSSettlement, we are working with our settlement members to evaluate market demand for and the viability of potential PvP solutions. 

We believe that implementing global standards and best practices in the FX market to mitigate settlement risk further is best achieved through close collaboration between the public and private sectors. The recent updates to the FX Global Code, which were achieved through consultation of local FX committees and market participants, is a perfect example of this approach.  

“We believe that implementing global standards and best practices in the FX market to mitigate settlement risk further is best achieved through close collaboration between the public and private sectors.”

At CLS, we will continue to support the FX Global Code objectives regarding mitigating settlement risk in two ways: through exploring alternative PvP designs which will provide access to PvP settlement for currencies that are not currently eligible for CLSSettlement, and by further expanding access to CLSNet, our automated and standardized bilateral FX payment netting calculation service. 

The collaboration with Finastra, one of the world’s largest fintechs, to provide Finastra customers with access to CLSNet3 is a good example of our strategy to diversify connectivity options to CLSNet. The move addresses increased demand from the buy-side for a centralized infrastructure to manage post-trade processes.

Now more than ever, 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. By working with the industry and policymakers on these initiatives, CLS will be supporting industry best practices and standardization while mitigating risk and reducing cost for market participants.

3Subject to all necessary approvals