While the full effect of Coronavirus (Covid-19) remains to be seen, its impact is already unprecedented, creating challenges for companies across sectors on a global scale. For financial services, the pandemic is highlighting the importance of operational resilience, a priority that will continue to be a focal point well beyond the lifecycle of the pandemic.
Before the emergence of Covid-19, the FX market had been experiencing an extended period of low volatility. The pandemic created market changes that resulted in negative investor sentiment, which in turn led to a significant jump in FX market volatility. During the recent period of extreme volatility in March, CLS volumes increased sharply. The average value of payments settled daily in CLSSettlement totaled approximately USD7 trillion - about 20 percent higher than normal. That spike in activity is itself indicative that the FX trading community remained extremely resilient despite social distancing initiatives that shifted organizations into remote working.
However, there will be lessons learned from the global impact of Covid-19, just as there are from any disruptive event. As the market continues to change and evolve, approaches to operational resiliency will focus on ensuring continued, seamless operation while maintaining the safety and stability of the FX market and the financial industry.
Historically, efforts to strengthen operational resiliency and mitigate risk have centered on financial market infrastructures (FMIs) because banks, fund managers, corporations and other market participants rely on FMIs for a variety of functions critical to financial markets: payments, custody, clearing and settlement.
Indeed, one key market segment provides an example of how market participants have turned to FMIs when seeking to become more resilient: pension funds.
Relying on FMIs to mitigate risk
Although it’s premature to understand fully how Covid-19 will impact pension funds, the sector was already undergoing a rapid and dramatic transformation ahead of the crisis. These changes were not driven by a sudden, singular event such as a natural disaster or pandemic.
Rather, over the past few decades pension funds have faced growing pressure to increase returns in order to support an aging global population. In response, pension funds and their appointed fund managers have diversified their portfolios across asset classes and geography. This trend toward foreign investments has resulted in a higher exposure to foreign currency in their portfolios and, potentially, increased exposure to FX settlement risk.
As of 2018, foreign investments accounted for roughly a third of pension funds’ total assets under management (34% of total pension investments, compared to 31% in 2014).1 Increasingly, this diversification is seen as necessary for the success of pension funds, as safe-haven investments are less attractive in a trading environment experiencing consistently low interest rates.
As their FX exposure increases, pension funds have new factors to consider, and generally these considerations span across the front, middle and back office. Asset owners reviewing the magnitude of currency risk exposure in their investment portfolios are weighing developed versus emerging market currency exposures versus any projected volatility of their home currencies, as well as best execution.
Alongside this review, asset owners need to determine their strategies for currency management. They need to decide whether to hedge or un-hedge, and at what levels. In addition, they must develop an understanding of the challenges associated with implementing currency risk solutions, primarily cost and liquidity. The potential settlement risk, impact on liquidity management, and additional operational burden that comes with hedging a portfolio are also key considerations. For pension funds, this results in continuous conversations with their custodians - and where relevant, their externally appointed managers - around the options available to mitigate FX settlement risk, optimize liquidity and improve operational efficiency. A growing number of pension funds are looking to mitigate risk through FX solutions offered by their custodians, including FX execution, timely reporting, netting and payment-versus-payment (PvP) settlement. (See Figure 1.)
Regulator recommendations underscore resilience
The development of Covid-19 continues to highlight the importance of mitigating risk and operational resilience. Should this result in further banking and financial reforms, regulators and the industry may look to FMIs to reliably provide support and vital services. In the past, regulators have endorsed operational approaches that mitigate risk and bolster resilience by leveraging the power and trustworthiness of FMIs. The Basel Committee on Banking Supervision (BCBS) first published guidance for managing settlement risk in FX transactions in 2000 (updated in 2013). The guidance recommends approaches for supervisors and banks on how to manage FX settlement risk, and specifically recommends using PvP arrangements where practicable to reduce settlement (or principal) risk when settling FX transactions. A PvP settlement system ensures that both sides of an FX trade settle simultaneously, mitigating the risk that would exist if one party to the trade delivers the currency it sold but does not receive the currency it bought from its counterparty. Without it, counterparties have to rely on non-PvP settlement arrangements such as bilateral gross settlement, bilateral net settlement and “on-us” settlement.
The global pension fund industry’s rapid growth and expanding interest in alternative investments have drawn the attention of regulators, which likely will drive new or increased regulation, governance and transparency. The natural response to this will likely be a focus on operational resilience and risk management. It would not be surprising if some of the financial and operational challenges created by Covid-19 likewise attracted additional regulatory attention, with a focus on operational resilience.
Ahead of the pandemic, a number of firms including some of the largest pension funds bolstered their commitment to operational excellence by signing up to the FX Global Code, a set of 55 principles established through collaboration between central banks and market participants from 16 jurisdictions to promote the highest ethical standards and best practices for the FX market.
Its purpose is to promote a robust, fair, liquid, open, and appropriately transparent market in which market participants can confidently and effectively transact at competitive prices that reflect available market information and in a manner that conforms to acceptable standards of behavior.
Like the BCBS guidance, the FX Global Code recommends using a PvP settlement mechanism whenever practicable to reduce settlement risk. As the industry increases its focus on operational resilience as a result of Covid-19, it is likely that a growing number of firms will commit to the FX Global Code, ultimately relying on FMIs to provide PvP settlement to safeguard their operations.
Potential implications of the pandemic
Although it is premature to draw conclusions during an ongoing crisis, Covid-19 has already reinforced the necessity of proactive planning and rapid response by governments and central banks. Stress testing ensured systemically important banks had adequate capital to withstand sudden shocks while continuing to provide credit to households and businesses, and during the recent period of extreme volatility, CLS processed the corresponding spike in volumes without problems or delays. As in the financial crisis in 2008, throughout the pandemic banks have relied on CLS with confidence that their trades would settle on time and with finality.
As the conversation around industry resiliency evolves, technology is an area more likely to be viewed through a lens focused on operational resilience. In recent years, blockchain, tokenization, and other innovations have raised the possibility of re-engineering the payments, clearing, custody and settlement space. As service providers and regulators review new technologies, they will want to ensure that enthusiasm to increase efficiency does not overshadow or degrade current levels of operational resiliency.
Covid-19 reinforces the need for new technology at minimum to demonstrate the current level of resilience – although ideally, innovations would enhance resiliency – before FMI boards and regulators allow their use for systemically critical services.
During and following the pandemic, the industry will not only continue to prioritize planning, but firms will broaden their considerations when ensuring operational resilience. For FMIs, specifically, it is not sufficient to merely be operationally efficient. They must also have multiple back-ups and resiliency strategies that address a range of scenarios impacting premises and staff. These strategies must be carefully planned and extensively tested to ensure delivery of service to the standards users require.
When evaluating the potential impact of various events, banks typically plan for financial crises or physical events that cause outages. However, Covid-19’s most significant impact has been on human resources. Looking ahead, banks, institutional investors and FMIs will likely plan for an expanded array of potential scenarios, including some disruptions that may be considered extremely unlikely. Before the pandemic, an event capable of stalling most of the global economy may have seemed far-fetched to many.
As the FX market continues to evolve through structural change, new technology, regulatory reform and lessons learned from disruptions and crises, market participants must navigate changes efficiently. As demonstrated through pension funds’ increasing focus on mitigating settlement risk through use of PvP, solutions that rely on the stability and security provided by an FMI are a solid option, sanctioned by regulatory guidelines.
Likewise, as the industry conversation around operational resilience evolves during and following Covid-19, market participants will continue to look to FMIs for resilient, secure and scalable solutions to safeguard and ensure the resilience of the FX market and the broader financial industry.