Ronn Baker

How PvP can reduce FX Settlement risk, funding costs and liquidity obligations

December 2022 in Supplements

By Ronn Baker, Senior Director of North American Sales, Baton Systems

Payment vs Payment (PvP) settlement is essential for the safe settlement of FX trades – ensuring that the transfer of assets is both secure and final. When settling in this manner a participant pays their currency, but it is delivered if, and only if, the final payment of the opposite currency is made by their counterparty. The PvP mechanism provides confirmation that both counterparties have made the required payments and once confirmation takes place, legal transfer of ownership is executed – therefore eliminating settlement risk exposure.

How does access to PvP need to be extended?

The traditional PvP market arrangement for reducing settlement risk has delivered tremendous value to the industry since it was first introduced in the early 2000’s. However, coverage is limited to 18 currencies and the direct global participants total around 74. Running an account at a central bank is a prerequisite, so direct membership tends to be restricted to the world’s very largest banks. It’s also limited to particular transaction types, partially due to the batch-based nature of the construct.

There is significant and growing demand for greater access to PvP on a counterparty, currency and product basis. This is reflected in the FX Global Code1 which stresses the importance of PvP, comments made by the BIS2 and the July 2022 BIS Committee on Payments and Market Infrastructures (CPMI) call for comments on facilitating increased adoption of PvP3. Based on this trajectory, I strongly believe that it’s not a matter of if, but when regulators will start holding banks accountable to PvP. Banks want to eliminate settlement risk. They want to reduce exposure and increase currency and counterparty coverage across an increasingly diversified FX market structure. We know for example there are 120 currencies out there, including currencies in which we’re seeing double digit growth for which there has traditionally been no means to safely settle via PvP.

The PvP mechanism we have developed at Baton Systems provides a proven and viable option for banks to extend the benefits of PvP settlement across a much broader range of counterparties and currencies. This is a live solution being used by tier one banks to net and settle billions of dollars of FX transactions between institutions every day.

Offering an alternative to batch-based processing, Baton’s PvP framework cuts the settlement timeframe from 24 hours to a matter of minutes. It’s important to stress that the PvP mechanism does not require central bank money and uses commercial bank accounts instead – so access to a central bank account is not a prerequisite for potential users.

Eliminating this dependency also means that Baton is able to work with its bank clients to extend PvP settlement to currencies in new jurisdictions quickly and with comparative ease.

How is the next generation of PvP solutions relevant in the context of improved liquidity management and reduced funding costs?

As the market volatility we’ve seen over recent months continues to increase this is generating a major stress point for banks due to the requirement to retain appropriate nostro balances in given currencies. Banks often lack the data necessary to accurately predict when counterparty payments will be made or indeed the timing of their own payments – further fueling the need to maintain large nostro balances.

However, through access to more transparent PvP mechanisms, they can gain this much needed visibility and more effectively predict upcoming demand. Baton’s PvP mechanism allows institutions to see transactions in real-time, with the certainty that they’re matched and confirmed, so they can then automate the post-trade process and set-up configurable agreements with their counterparties to agree the terms of settlement, to settle at specific times of the day, and do so multiple times a day.

Additionally, if banks can more effectively predict when transactions will come through they can set-up processes such as automated netting to execute with a given cadence. By increasing the proportion of transactions that are then effectively netted, banks can further reduce the total amount of currency required to be settled between counterparties, and then quickly and efficiently settle these netted values via PvP.

How can next generation PvP mitigate other frictions in cross border payments?

PvP processes can also help mitigate multiple additional frictions in cross-border payments, a prime example is how recent advancements in PvP technology can enable banks to shorten the overall time it takes to process long transaction chains. In the post-trade environment we’ve traditionally seen transactions take two days or longer to settle.

However, due to the ability for Baton’s technology to interoperate with the bank’s existing systems, to deliver transparency and automation throughout the reconciliation process and settlement cycle, we’re able to reduce the time it takes to settle a transaction from initiation to completion to a matter of minutes. So, next generation PvP that’s available on-demand in an expedited and secure manner reduces settlement risk, ensures finality of payment and allows for the rapid redeployment of funds multiple times throughout the trading day.

Additionally, with greater predictability of upcoming funding requirements banks can minimise large single payments and associated concentration risk. This offers significant benefit, especially in the current rising interest rate environment where the cost of maintaining large balances is only likely to present increased sensitivities within banks. Ultimately advancements in both the availability and functionality of PvP mechanisms offers significant potential for the wholesale banking community.