While foreign exchange (FX) transaction volumes have skyrocketed, FX post-trade systems and processes have largely remained unchanged. As a result, managing operational risk and improving efficiencies remains a constant challenge for many firms operating siloed and legacy, batch-based systems that are expensive to maintain. These operations are dependent on costly and error prone, manual interventions – where the custom processing of “exceptions” constitute the norm. Ultimately, it’s a 21st century problem in desperate need of a 21st century technology solution.
The good news is developments in distributed ledger technology (DLT) have created opportunities to vastly reduce post-trade operational risk. DLT delivers core structural business benefits as data is centralised and shared as a single ‘source of truth’, minimising time spent reconciling records. Additionally, operations teams can attain the speed, transparency, choice, auditability and non-repudiation they increasingly require. Through its resilience, DLT also offers great technology appeal and being cloud-based, upgrades and maintenance can be achieved with ease.
Furthermore, DLT empowers banks to streamline their entire end-to-end post-trade process from trade matching, through netting, to settlement. All of this can be achieved across traditionally siloed verticals. Resulting in assets that can be securely exchanged directly between counterparties with instantaneous transfer of ownership, avoiding intermediaries and time delays.
Foreign exchange post-trade operational challenges and the new tools available to address them
These challenges manifest during the four stages of an FX post-trade operation: confirmation, netting, settlement and post-settlement reconciliation.
Confirmation
The FX Global Code1 requires confirmation ‘as soon as practicable’. However, manual steps may leave trades unconfirmed for several days with the resulting market exposure being a key operational risk. In the absence of a timely and comprehensive confirmation process, trading parties are unable to confidently and accurately manage their market risk.
DLT transforms the confirmation process, primarily because all transaction data is stored in a shared location. Complete real-time visibility for all counterparties empowers a streamlined process. Communication channels are rationalised and issues with delayed confirmations can be easily identified and resolved.
Netting
Automated netting of FX transactions offers significant benefits since it reduces the total number of payments being made, in turn reducing settlement risk and minimising manual processes and the potential for error. However, legacy netting processes can delay agreement and prevent some trades being included in a netting set, eg. trades processed value date (VD)-1 often cannot be netted with same-day trades. Moreover, netting practices vary widely and can include hand-selected sets, calculation via Excel and manual steps. These manual practices can cause delays, further adding to operational pressures and in some cases penalties and costs.
DLT is now enabling configurable and automated bilateral netting where both parties are using the same data set with the same agreed calculation process. Furthermore, this process can be integrated with Payment-versus-Payment (PvP) settlement. The resulting process virtually eliminates the need for manual intervention, optimises operational efficiencies and supports multiple recent industry calls to increase netting including the May 2022 Global Foreign Exchange Division’s (GFXD) recommendations for reducing settlement risk2.
Settlement
One of the pertinent post-trade risks for operations teams is delayed or failed settlements, usually due to a lack of confirmation or unagreed netting and potentially amounting to a regulatory breach.
Taking a wider market perspective, failed settlements can result from or contribute to market deadlock where, for example, trades are in illiquid currencies. In many instances, where banks have offsetting obligations and are awaiting receipt of an illiquid currency as the cut-off time for settlement approaches, they face an invidious choice of delaying payment and incurring penalties, or paying and either funding through the cash market (frequently very expensive at short notice, if possible) or going overdrawn (if permissible in the context of their nostro account relationship).
Advancements in DLT puts transacting counterparties in the driving seat. Netting and settlement via PvP can take place multiple times intraday. With DLT, settlement triggers are pre-agreed, built into smart workflows and the complete settlement process completed in a matter of minutes from initiation. As a result, operational risk from late payments is programmed out of the process and shared, visible data affords all parties assurance of the trade’s current status.
These processes not only reduce risk for existing business lines, they also allow firms to expand their trading relationships into areas that would previously have been inaccessible under their risk management framework.
Post-settlement reconciliations
In almost all cases, the major banks continue to reconcile their FX payments and receipts on the day following the intended settlements. This is invariably a complex and time-consuming process. Different business silos share nostro accounts, counterparties may have elected to split payments without pre-advice, and the sheer number of individual payments (many of them in standard sizes) is vast. The consequence of a delayed reconciliation process is that firms are implicitly accepting that information about the performance of their counterparties is delayed, often by more than 24 hours, a period during which additional payments may continue to be made.
Clear benefits of DLT
A DLT solution performing PvP settlement monitors (by definition), the successful completion of each settlement event. In turn this allows the real-time evaluation of outstanding settlements through the twin lenses of counterparty and currency as well as eliminating the burden of the existing manual process.
Overall, the adoption of DLT offers an exciting opportunity for FX firms to transform their post-trade risk management, minimising costs and delays. This readily available technology enables teams to move away from maintaining the status quo and simply running the bank, to building the bank with the level of innovation that tomorrow’s markets will require.
1 https://www.globalfxc.org/docs/fx_global.pdf
2 https://www.gfma.org/wp-content/uploads/2022/05/reducing-settlement-risk-may-2022.pdf
