Payment versus payment (PvP) settlement offers FX market participants plenty of benefits—benefits that every stakeholder recognizes. However, the rising proportion of non-PvP settled trades tells a different story.
“Whilst incumbent PvP arrangements protect a significant proportion of daily FX settlements from settlement risk, it is well-recognised that such arrangements are not available to all segments of the FX market,” says Jarrad Hubble, CEO of RTGS.global. “Many emerging markets and developing economy markets, for example, do not have PvP solutions available to them, despite trading in their currencies having increased over the years.”
While rising EM currency demand and their presence outside CLSSettlement is a major contributor to this trend, is there a technological reason behind rising settlement risk?
Basu Choudhury, Head of Partnerships and Alliances at OSTTRA, doesn’t think so. “The issue here isn’t the technology or the way the technology was developed,” he says. “When CLSSettlement was designed and developed its focus was to address the large risk in the interbank FX market.”
He says that while the multilateral batch model works well to deliver value to these participants, recent growth in non-bank flow is making this model ill-suited.
“The rigidness of the model is not well suited to help mitigate this risk as it implies much larger liquidity backstops and/or greater risk for the settlement agent who is intermediating on behalf of the non-bank client,” Choudhury explains.
So what does the future hold for PvP, and what role will technology play in it?
Technology as a solution
Designing a new system to accommodate recent changes in flow is challenging. Market fragmentation caused by new solutions and the unproven resilience of new technologies are just two of the obstacles. Given these challenges, Dirk Bullmann, Managing Director, CEO office at CLS, believes FMIs are best suited to tackle them.
“While we welcome new approaches aimed at reducing settlement risk in the FX market, it is crucial to weigh the benefits of any new solution against the risk of market fragmentation. This fragmentation could potentially reduce market efficiency, re-introduce risks and increase funding costs,” explains Bullmann.
“FMIs, as regulated entities bound by strict rules and standards, play a crucial role in safeguarding the financial industry. These standards ensure that the infrastructure supporting global financial markets is resilient, particularly during times of market stress.”
In addition, Bullmann highlights that FMIs have best-in-class risk management practices, scalability and regulatory experience – positioning them well to develop new solutions to address evolving market needs. “The effectiveness of the FMI model in mitigating FX settlement risk is evidenced by the increasing PvP settlement values and the growing CLSSettlement community,” he says. “Since 2021, CLSSettlement values have increased by 8%, reaching an average daily settled value of USD7 trillion currently”.
“New FX settlement solution providers may also seek to enhance efficiency by offering their settlement rails to further mitigate other cross-border payment frictions,” Hubble says, “such as slow and expensive movement of funds due to long transaction chains, limited hours of functionality, expensive credit, credit risk, opacity as to the status of a payment, and trapped liquidity, most of which are a direct result of over-reliance on the traditional correspondent bank network.”
“The time is right for new initiatives to provide services to an expanded set of markets and industry stakeholders, especially where there are clear opportunities for and from more efficient cross-border payments but a lack of availability of PvP and streamlined global payment mechanisms.”
The question of overcoming legacy technology’s restrictions always arises when discussing the development of a new solution. The past few years have seen blockchain and DLT systems gain popularity. Can these be a solution for PvP?
Choudhury is quick to point out a nuance in this line of thought. “The key concept is not blockchain, rather it is distributed data, shared workflow and peer-to-peer interactions where a trusted operator (CeFi) provides legal and operational certainty to participants in a closed ecosystem,” he says.
He explains that merely creating a so-called golden record of a transaction is not enough. “When you say you have this golden record, what you need to do is give the participant the ability to reconcile in real time with their current books and records,” Choudhury says.
In terms of shared workflows, he gives an example of flexible settlement based on flows. “Even though I owe you 100 million, it could be that I get 10 million every hour,” Choudhury says. “I want that flexibility to be able to say ‘Can we split that 100 million into lots of ten every hour’, or ‘I have a regular schedule where I know my DVP settles in X time’. Can we have these batch processes or intraday runs where we can settle bilaterally?”
He acknowledges that this system will introduce a new form of commercial bank risk. “Broad adoption in wholesale markets will require either synthetic CBDC or wCBDC to scale,” he notes. “RTGS.global and Fnality are attempting to implement this type of model however it needs access to either central bank accounts or direct access to local payments infrastructure (RTGS systems), both of which have high compliance overheads and will take time.”
Alex Knight, Head of EMEA at Baton Systems, says DLT in post-trade processing can smooth the T+1 transition. “DLT allows workflows to be automated and collaborative,” he says. “These workflows permit event- or time-based processing to happen in a mutually agreed, consistent, and transparent manner.”
“One example is the process for PvP settlement, by which exchange of ownership occurs instantaneously and simultaneously, an event that only occurs when both parties have funded the appropriate (and secure) settlement accounts.”
He explains that shared data can include not only data around the transaction economics but also data related to the settlement process. “For example, the standing settlement instructions that are to be used for a certain settlement event,” he says. “This shared data reduces the need for ongoing reconciliation and reveals mismatches early in the process, meaning that the operations team is more ready to handle the settlement process.”
wCBDCs are the most promising technology on offer right now, but Choudhury notes that they’re still a few years away. “These types of Micro structures evolve over many years with close collaboration between private sector (the operator) and public sector policy makers,” he says.
He is quick to point out that while wCBDCs are a great starting point, liquidity-efficient settlement solutions need resilient and robust ecosystems where value transfer can be facilitated securely.
Bullmann concurs and adds, “There has been an increased focus on wCBDC, and significant advances have been made in the work around cross-border payments. However, the jury is still out on the role wCBDCs could play in cross-border payments, wholesale PvP settlement and the FX ecosystem generally, and further analysis should consider legal, regulatory, governance, political and other non-technical issues to ensure systemic stability.”
Standardisation and reducing stratification
Standardisation is often a great way to improve efficiency in any process and settlement is no different. Frameworks such as ISO20022 messaging can potentially improve efficiency, but they are ineffective without the right processes backing them up.
Bullmann underscores the significance of standardization and automation in tackling risk. CLSNet – a standardized and automated bilateral payment netting calculation service – is designed to mitigate operational risk and improve operational and liquidity efficiencies for currencies ineligible for PvP settlement in CLS. The service facilitates the reduction of payment obligations exposed to settlement risk while improving operational and liquidity efficiencies. “We believe that the true benefits of the bilateral netting calculation process can only be realised through a centralized and standardized industry utility model, supported by an underlying rulebook. Crucially, such conditions are essential for generating a network effect that maximises benefits for FX market participants,” he says.
Meanwhile Choudhury adds, “Technology on its own does not solve the issue, standard workflows and handshaking will be crucial.” He believes that standardisation can make intermarket settlement linkages more efficient.
“Banks typically receive thousands of daily payments into an account for a given client (or multiple end clients when there is an omnibus structure),” he says. “The subsequent allocation of these funds to the end client normally involves reconciliations and links to the obligations that generated the receipt of funds, today many banks will only perform this exercise at EOD.”
He believes adopting Swift GPI can simplify this picture and enable banks to track and allocate funds intraday. “However the dependency is with the sender to identify at the point of funding not only who the end beneficiary is but to also indicate what obligation they are fulfilling,” he says. “This could be a single FX trade or more likely it is a netted FX obligation.”
Hubble notes that despite complexities, the market does not need a “Big Bang” approach. “In collaboration with the banking community and the wider financial ecosystem, a phased and controlled approach is preferred, with a focus on regional growth and/or proving out individual business use cases first,” he says.
Participant stratification is a common theme in financial markets. Sophisticated and well-resourced participants drive requirements and ultimately regulation causing complexity for smaller participants. Will PvP follow a similar route? Is preventing such an outcome for PvP even possible?
Choudhury feels that this phenomenon is how markets naturally evolve. “The FX markets still do not have clearing mandates and will likely never,” he says. “In such situations, a trusted FMI plays an important role in ensuring that smaller firms have relevant means to access these services.”
However, he says that FMIs must be incentivized, either financially or through regulatory mandates. “At this juncture, the FXGC is seen to be a sufficient lever for PvP,” he says.
Standardisation also leads to more interoperability, currently a major challenge in FX. “Many banks hold few direct settlement memberships, and unless they have a global footprint are often only members of their domestic currency settlement system,” Hubble says.
“While this approach can work efficiently for transactions within a limited range of currencies, it presents challenges when transacting in any of the world’s many other currencies.”
“Interoperability serves a critical function in fostering financial inclusion,” he continues, “especially in the context of integrating opportunity/developing markets into the worldwide financial ecosystem.”
Much depends on the way policy decisions are conducted—whether they are based on the right data. FX has an inherent problem in this regard given the large number of non-bank participants and market fragmentation.
Technological flexibility and turning settlement into a low-touch activity
Transforming settlement from a high to low-touch activity is something market participants wish. However, the path remains long despite advances in technology. “Much of the flow today is low touch and the remaining flow, largely the non-bank and EMDE, is more difficult as their needs and requirements are very diverse,” Choudhury says.
He notes that many intermediaries in the ecosystem are investing large sums to address these gaps in the back-end infrastructure. “Does anyone know the full path to a fully automated financial markets ecosystem?,” he continues. “No. However, the jigsaw is becoming clearer but will take time to execute the vision.”
And what role can technology play in simplifying the picture? “Today’s technology allows for the creation of a golden record with distributed data and peer-to-peer interaction with netting, payment shaping, and settlement,” Choudhury responds. “Cloud services offer off-the-shelf tools, greater reach, and lower costs as the service provider can host for smaller participants.”
Cybersecurity is a challenge here though, potentially raising barriers to entry for smaller service providers.
Hubble believes increasing technological familiarity is playing a role in driving wider PvP adoption. “With central banks becoming more comfortable with entities storing their liabilities on an external computer system, including in the cloud, this potentially enables a technological and regulatory framework that supports faster, cheaper and more secure exchanges of value across borders,” he says.
“This in turn creates the right circumstances and incentives for the development of regional settlement services, supporting regional unification, including of financial markets, and/or extending the currency reach of such regional settlement schemes.”
Knight notes that extending buy-side access to PvP is critical. “Quite aside from the concerns about increasing settlement risk,” he says, “buy-side participants will find themselves wrestling with a difficult set of challenges; retaining access to (and evidence of) best execution and avoiding performance drag, whilst ensuring operational efficiency and integrity.”
“Extending access to PvP settlement is an important lever in ensuring that buy-side participants meet these important objectives,” he continues. “It gives them the opportunity to retain control over execution without concerns or limitations caused by settlement risk, whilst confident that the funds will settle in time to meet their underlying securities settlement obligations.”
Ultimately, the combination of technology backed by the right legal and regulatory processes is critical.
Bullmann at CLS concludes, “To ensure the safe and effective implementation of any new PvP solution with systemic risk implications, the relevant legal, regulatory and policy aspects need to be considered alongside the technology delivering the solution”.
“Technology is important, however legal and regulatory considerations are paramount to any form of settlement, either PvP or DvP,” Choudhury says. “There is however a role for a trusted operator to link into these new forms of settlement.”
“A truly global settlement network backed by central bank funds has the power to open up new currency corridors in any developing and opportunity markets—whether that’s Central, Middle and Southeast Asia, the Near East, the Caribbean, or the Pacific Island —to the rest of the world,” Hubble says. “Starting regionally, we are witnessing a monumental step forward towards universal interoperability between payment systems and other key infrastructures in the financial markets ecosystem.”
Ultimately, while PvP’s progression remains challenging, technology is enabling greater adoption, with FX stakeholders paving the way for better settlement.