Takeshi Shirakami

Assessing the extent and nature of the FX settlement risk problem

September 2021 in Supplements

The Bank for International Settlements’ (BIS) Triennial Central Bank Survey is a key bellwether of the state of the global foreign exchange market. We explore the findings of the latest survey with Takeshi Shirakami, Deputy Head of Secretariat of the BIS-hosted Committee on Payments and Market Infrastructures (CPMI), to examine what can be done about the increasing FX settlement risk, including the role of industry supervisors in tackling it.

What does the latest Triennial survey data tell us about FX market activity and how big a threat increased FX settlement risk is becoming?

The results of the 2019 BIS Triennial survey tell us that the FX market continues to grow, as does FX settlement risk.

The survey data tell us that the share of total FX settlement obligations subject to settlement risk grew from 50% to 60% between 2013 and 20191. In April 2019, average daily global FX trading of $6.6 trillion translated into gross payment obligations worth $18.7 trillion, after taking into account the number of payments for each instrument. Bilateral netting reduced payment obligations to $15.2 trillion. About $6.3 trillion was settled on a payment versus payment (PvP) basis using CLSSettlement or a similar settlement system. This left an estimated daily $8.9 trillion worth of FX payments at risk. FX settlement risk remains significant. Moreover, once materialised, it could have a significant second-round effect on the global financial system. Losses could be large since FX contracts involve the exchange of principal amounts of currencies traded. Such incidents would likely lead to overly precautionary behaviour among FX market participants withholding outgoing payments before receiving incoming ones where PvP settlement is not available, which could create a severe stress scenario for broader FX markets. This is exactly what happened in the summer of 1974 when the Herstatt Bank collapsed.

Generally speaking why are FX settlement risks on the rise?

There are several possible explanations for this in my view. First, changes in the FX market structure might have contributed to the higher share of payments without PvP protection. For example, some types of transactions may require additional operational steps and arrangements to be settled on a PvP basis, which may discourage the use of PvP. Second, some FX market participants may not have access to PvP services or may not have enough incentives to use the service offered. Third, trading in currencies that are not eligible for PvP systems has grown. The CPMI considers that digging into these potential explanations is important but would require more granular information on the structure of FX markets.

There has been a contraction in the number of correspondent banking channels. What impact is this having on FX settlement risks?

The contraction in the number of correspondent banking channels and FX settlement risks are separate issues. One thing we do know is that correspondent banking and FX markets are highly concentrated and the key players are more or less the same. The contraction in the number of correspondent banking channels could, although does not have to, lead to a rising share of FX payments via the same settlement bank, i.e. “on-us settlements.”2 With on-us settlements, both legs of settlement may or may not be final and irrevocable, i.e. may not have PvP protection. Here again, it would be useful to get more granular information about how on-us settlement operates in practice, how robust it is and how the decline in the number of correspondent banking channels contributes to concentration in settlement bank services. Apart from its potential impact on FX settlement risk, the decline in correspondent banking channels is itself an issue of significant concern. Addressing this issue is one of the key focus points in the on-going G20 work for improving cross-border payments. As part of this broader G20 work, the CPMI published a report in July this year, which set out 19 “building blocks” of a global roadmap for enhancing cross-border payments.3 Some of these aim to address the issues related to correspondent banking such as consistent and comprehensive application of the rules for anti-money laundering/combating the financing of terrorism (AML/CFT) and promotion of safer payment corridors.

The on-going work on cross-border payments is quite relevant also to reducing FX settlement risk. While its scope is broader and the project is multifaceted, it includes a building block on facilitating increased adoption of PvP to improve cross-border payments (Building Block 9). Going forward, the CPMI, together with the Basel Committee on Banking Supervision (BCBS) and relevant authorities, will be encouraging the adoption the 2013 BCBS Supervisory Guidance on managing FX settlement risk,4 and we will be encouraging FX committees to support the Global FX Code principles. The CPMI will also take stock of PvP arrangements, analyse drivers for non-PvP settlement and develop proposals for increased adoption of PvP.5

Shadow payments systems which are outside the control of lawmakers and regulators are also on the rise. How much are they contributing to the problem?

Often shadow payment arrangements settle transactions by moving money between customers’ accounts on their books.  Consequently, users are just as exposed to the liabilities of the entity that is not regulated as a deposit taking institution both before and after settlement as they are during the settlement process.

In my view, the concern with shadow payment systems is much broader than just FX settlement risk. They often lack basic risk management, legal certainty, consumer protection, financial integrity or cyber security. This highlights the urgency of improving cross-border payments so that market participants do not turn to shadow payments out of necessity.

Can the challenge to get countries to make their payments systems interoperable be overcome and if so what impact would that have on reducing risks?

The harmonisation of clearing and settlement procedures and messaging standards do not necessarily affect FX settlement risk. However, they do have an impact on the speed, efficiency and cost of cross-border payments. That is why enhancing data and market practices, including the adoption of a harmonised ISO 20022 version for message formats, is one of the focus areas of the G20’s work for enhancing cross-border payments.

Legal issues are involved in connecting payment systems in different jurisdictions. How much of a difficulty and obstruction to providing solutions to the settlement risk problem do these represent?

PvP settlement systems often involve connecting payment systems in different jurisdictions, which gives rise to certain legal issues. For instance, differences in settlement finality rules may lead to a scenario where a payment is regarded as final in one jurisdiction but not in the other. Moreover, it is more likely that cross-border systems face issues arising from a conflict of laws, e.g. ambiguity as to which jurisdiction’s laws apply. Closing such legal gaps sometimes requires new legislation or even treaties, and consequently will require a considerable amount of time and resources to address.6

How much could better regional monitoring of the FX market help to detect and deal with FX settlement risks?

More frequent data collection on FX settlement risk would help us develop a deeper and timelier understanding of the market practices and associated risks as the FX market structure and back office arrangements continue to evolve. In this regard, we welcome on-going dialogue among members of the Global FX Committee (GFXC7) and its regional FX committees to enhance their data collection. The regional FX committees collect data on their respective FX markets more frequently than the BIS Triennial survey, so I think it would be helpful if these regional surveys included questions on FX settlement risk.

Are some regions of the world likely to see the threat of FX settlement risks increasing more than others over the next few years?

One of the reasons for the relative increase in FX settlement risk is the growth in trading in currencies that are not eligible for settlement in a PvP system. Increased activity in emerging market (EM) currencies could lead to an increase in FX settlement risk unless the availability of PvP is widened to include these currencies. However, just because the risk is related to EM currencies does not mean that EMs bear the risk; it is the counterparties to a trade, wherever they are based, that bear the risk and must manage it.

That said, I would argue that once the threat of FX settlement risk has materialised in a stressed market scenario, jurisdictions whose currencies are not eligible for PvP settlement may be more susceptible to precautionary payments freeze and broader FX market seizure.

How can local and regional banks be encouraged to do more to combat FX settlement risks, for example by trying to make their FX liquidity management a less complex and more joined up process?

An individual bank can evaluate its FX settlement policies and procedures against the 2013 BCBS Supervisory Guidance on managing FX settlement risk. Such action by individual banks should be complemented by collective industry-wide dialogue and cooperation, such as the work of the GFXC.

In recent years, an increasing number of central bank wholesale payment systems, i.e. real-time gross settlement systems (RTGS) have extended their operating hours, or are considering doing so. Greater overlaps in operating hours between central bank payments systems from different time zones help to reduce, though not eliminate, the duration of payments exposures between the final payment of one leg and receipt of the other leg. Extending operating hours requires close coordination within and across local jurisdictions.

What issues and considerations have the fast growing digital asset and cryptocurrency markets thrown up with respect to FX settlement risk?

To the extent that these types of payments are unregulated, i.e., shadow payment systems, the concern is broader than the risks associated with the settlement process. Highly volatile crypto-assets such as Bitcoin would not be well suited as a settlement asset in the first place in my view. I have some doubt about their legal soundness in ensuring PvP. More generally, the CPMI is closely following private-sector initiatives in wholesale digital payments also in relation to their potential use in FX settlement.

As the FX market continues to evolve with new products and new participants utilising new technologies, has the BIS identified any new types of potential FX settlement risk we should all be concerned about?

New FX products do not necessarily affect FX settlement risk, as long as the payment obligations can still be settled on a PvP basis. However, new participants may not have access to PvP settlement systems or may not manage their FX settlement risk as rigorously as traditional market participants are required to do.

Faster and interoperable data exchange with new technologies may help market participants, especially those that are active globally, to obtain and aggregate information from a large number of correspondent bank accounts in near real time, and to monitor and control incoming/outgoing payments and liquidity. Such innovative services will be useful to individual market participants in addressing FX settlement risk. However, I don’t think they are a complete substitute for PvP mechanisms. More efficient and timely monitoring and control by individual market participants will help protect them but could inadvertently lead to payments freezes in a stressed market. A PvP mechanism by contrast could incentivise early payment submissions, since payers know for sure their payments will not be processed unless incoming payments are also processed. It can work as a coordinating, and stabilising, device during periods of heightened uncertainty.

The views expressed are those of the interviewee and do not necessarily reflect those of the Bank for International Settlements, the Committee on Payments and Market Infrastructures or its member institutions.

  1. Bech, M and H Holden, “FX settlement risk remains significant”, BIS Quarterly Review, December 2019, available at https://www.bis.org/publ/qtrpdf/r_qt1912x.htm 
  2. “On-us” settlement is where both legs of FX trades are settled across the books of a single institution.
  3. See report here: https://www.bis.org/cpmi/publ/d194.pdf
  4. Available at https://www.bis.org/publ/bcbs241.pdf
  5. See Annex 2 of the October 2020 Financial Stability Board Report “Enhancing Cross-border Payments – Stage 3 roadmap”, available at https://www.fsb.org/2020/10/enhancing-cross-border-payments-stage-3-roadmap/
  6. For further information on the challenges of linking payment systems see Bech, M, U Faruqui and T Shirakami “Payments without borders”, BIS Quarterly Review, March 2020, available at: https://www.bis.org/publ/qtrpdf/r_qt2003h.htm.
  7. Members of the GFXC include central bank-sponsored foreign exchange committees and similar structures in various regions.