In recent years, policymakers and regulators have renewed their focus on FX settlement risk.
At a meeting in December 2023, the Global Foreign Exchange Committee (GFXC) discussed the importance of maintaining a continued focus on topics such as FX settlement risk mitigation and enhancements to data transparency in FX transactions.
The committee noted that a number of local foreign exchange committees will this year begin to collect standardized FX settlement data as part of their semi-annual FX volume surveys, which will enable more frequent assessment of FX settlement risk.
The main growth in FX has been in the dealer to client segment over the last 10 years as well as emerging market and developing economies and much of this flow settles outside of existing PvP services.
Current PvP solutions mitigate risk for dealer-to-dealer flow, mostly involving banks participating in CLS, as well as buy-side flow through CLS’s settlement members that provide CLSSettlement to their customers (CLS third-party participants).
Basu Choudhury, head of partnerships and alliances at OSTTRA is confident that the issue of FX settlement risk has not been underestimated. But he also acknowledges that regulatory authorities and central banks have been reluctant to talk publicly about the impact of FX settlement risk for fear that negative commentary could lead to market uncertainty.
Valuable solutions
Unless there is a solution in place that helps firms mitigate this risk, any noise from central banks on this issue could lead to instability. In this context, the FX industry has an opportunity to pursue solutions that address risks but also provide value.
“Where regulations have been introduced in other asset classes, the proposals have been problematic for firms to implement and adopt,” says Choudhury. “With FX the industry has the opportunity to self-regulate and control the outcomes. But there is a limited timeline and should the industry not act, regulatory authorities may be forced to step in and mandate the way forward.”
According to Choudhury, the question of what steps banks could take to more fully address and manage FX settlement risk should be framed in the context of the need for automation in the post-trade process.
“There are numerous levels of ‘linkages’ within each stage,” he adds. “The challenge is that at the back end, for settlement the account could have thousands of daily payments so how do you associate or link this payment with a set of netted obligations or specific cash flow?”
Most firms only have the ability to link and automate the full stack where they manage the entire ecosystem for a client, normally if they are acting as a fund administrator or custodian. Even in this scenario it is likely that they will rely on a separate (correspondent) bank for settlement as they will not have direct access to central bank account and RTGS systems.
Understanding the degree of settlement risk
In collaboration with its members, CLS has analysed a subset of member banks’ trades to determine how they were settled to provide an indication of the market’s management of settlement risk and the range of mechanisms used to settle FX flows.
The findings showed that around 90% of the settlement risk exposure associated with their FX trades in the 18 CLS-eligible currencies was successfully mitigated via CLSSettlement with full PvP.
“Addressing settlement risk beyond CLS-eligible currencies may require an alternative solution,” explains Lisa Danino-Lewis, Chief Growth Officer, CLS. “Given its systemic importance, adding new currencies to CLSSettlement is an extended effort that is subject to several factors. For example, ongoing and crucial legal, risk and liquidity standards must be met in the jurisdiction of onboarding.”
Danino-Lewis explains that due to these limitations on access to CLSSettlement, CLS is focusing on growing CLSNet, its automated bilateral payment netting calculation service. The service automates the netting process via a standardized centralized platform, delivering greater operational efficiency and increased risk mitigation for currencies currently unable to settle in CLSSettlement.
She notes, “CLSNet is directly accessible to most market participants, including funds, corporates and non-bank financial institutions, making its benefits widely available to the FX industry. It has also experienced record growth in the last 12 months, underscoring the industry’s support for the service.”
Faster settlement
In February the SEC adopted amendments to shorten the standard settlement cycle for most broker-dealer transactions from the second business day after the trade date (T+2) to the first business day (T+1). The new regime came into effect on May 28th.
The Global Financial Markets Association (GFMA) notes that while T+1 is not a direct issue for FX, knock-on challenges occur because of the need to execute the securities transaction followed by the related FX transaction with compressed remediation time available.
T+1 FX settlement is challenging for a number of reasons. Many regulatory and operational considerations govern the FX settlement process, much of which comes down to the brokers and banks involved.
Taking positive actions on imperfect data could lead to an increase in error rates and therefore the costs of doing business observes Gerard Walsh, global head of client solutions, banking and markets at Northern Trust.
Risk mitigation
Walsh says the industry will need to stay on its toes to mitigate such risks and ensure steps have been taken to minimise negative consequences for investors from inefficient processing.
“We have seen increased interest in solutions that deliver the trade, matching, clearing and settlement process as well as trade-related FX in a single coherent lifecycle,” says Walsh. “We believe this trend will continue for as long as the settlement mismatch between the US and other major markets persists – in other words, for some years to come.
Executing the FX trade in a comprehensive trade lifecycle as close as possible to the time the underlying assets are traded can be achieved through an automated, tailored and programmatic FX funding mechanism that is linked as close to the underlying transaction as possible, along with flexibility in execution timing and access to global liquidity.
However, many firms do not have the operational processes to speed up workflows to ensure settlement takes place in this new shortened time frame. Some have looked for operational simplicity and had their custodians do more management of FX exposures, but this is likely to lead to an increase in transaction costs.
“I suspect some will have gone the other way and want to outsource these operational processes to specialist FX managers who can reduce transaction costs and manage settlements,” says Nathan Vurgest, director, head of trading at Record Financial Group, who refers to increased demand for STP operational services.
“The value-add is in a manager who can accurately review trade requirements and act in the short time frame needed at minimum cost of execution,” he adds.
Limited impact
At the beginning of April, CLS announced that it would not make any operational changes to CLSSettlement ahead of T+1 implementation in the US in May 2024.
This decision was based on a member survey, asset manager outreach, as well as analysis of CLS transaction data to assess how the move to T+1 could affect asset managers and funds.
“Asset manager outreach combined with CLS’s analysis of its transaction data indicated that a value equivalent to 0.4% to 0.5% of CLSSettlement average daily value could be impacted by the move to T+1 in US Securities, ”observes CLS chief growth officer, Lisa Danino-Lewis. “More than 50% of asset manager respondents said the majority of their risk could still be mitigated through CLS even without any changes to custodian cut-offs or deadlines, while 35% have not yet decided how to respond to the impact of T+1.”
“Following the T+1 implementation, there has been no reduction in CLSSettlement’s average daily value (ADV). In fact, we have seen an increase in CLSSettlement ADV from USD6.6 trillion in 2023 to USD7 trillion (year-to-date). We will continue to monitor and analyse our transaction data and will provide updates as appropriate.” said Danino-Lewis. She added that “In the meantime, prioritizing execution and operational efficiency across the asset manager and fund community remains paramount, which is where solutions such as CLSNet can offer valuable support. We are also working closely with our settlement members, asset managers and the wider ecosystem to proactively explore possible solutions to address any challenges that may arise.”
Alternative approaches
Choudhury agrees that the move to T+1 ‘re-bilateralises’ FX settlement with managers that choose to miss or end up missing the CLS deadline having to settle bilaterally. However, he notes that firms are exploring other ways of addressing the issue.
Where possible firms may trade synthetic securities, which would allow them to benefit from price moves but not need to physically settle the securities – removing the need to trade and manage FX.
“Where a fund cannot trade synthetic securities, one option is to outsource FX execution and settlement to the custodian who manages their USD DvP,” observes Choudhury. “Both models have pros and cons but they do allow firms to avoid the potential for settlement failures in both their FX and securities activities. In the long term other countries will adopt T+1 models and the industry will require more flexible PvP models.”
As for what can be done to encourage wider industry engagement around the challenge of FX settlement risk, Choudhury refers to existing engagement by both banks (industry working groups) and buy-side customers.
“We have seen a real appetite for our bilateral PvP service,” he adds. “We are in the process of growing the ecosystem and see this as a complementary ecosystem to CLS as the coverage is focused on the flow (either participant, duration or currency) that may not be efficient or practical within a multilateral PvP model.”