How SWIFT can help to manage FX settlement risk

With over $18 trillion settled globally each day, it has never been more important for our community to find innovative ways to reduce settlement risk.

There’s no doubt that the growing amount of FX settlement risk represents a complex and significant challenge for the entire financial industry. With over $18 trillion settled every day¹ from a variety of different FX instruments with their own settlement periods, it’s no small feat. But that’s not where the complexity stops. On top of this, there are also over 400 currency pairs traded by thousands of financial firms over hundreds of different platforms, in over 200 jurisdictions and numerous time zones. 

To help understand the nature of this challenge and how to address it, we commissioned e-Forex to produce a set of articles on FX Settlement Risk. Our objective was to bring together some of the leading industry experts to dissect the problem, examine what solutions exist today and see what could be done in the future. At the same time, the Financial Stability Board (FSB) released their Stage 3 report on enhancing cross-border payments which included a ‘Building Block’ called ‘Facilitating increased adoption of PvP’ that directly addresses the topic of FX settlement risk.

Managing settlement risk with SWIFT gpi

CLS currently removes around $5.5 trillion of settlement risk each day, which according to BIS² is only a third of the total daily figure. This leaves more than $10 trillion of settlement risk to be removed by other means. BIS also estimates that the proportion of trades with PvP protection appears to have fallen from 50% in 2013, to 40% in 2019. Whilst a small percentage would settle via cross-account movements for the ‘on-us’ settlement process or internal account movements for intra-group trades, a significant proportion will settle via payment instructions through the correspondent banking process. Whether settled gross or settled net, each party sends an outgoing payment and expects to receive an incoming payment. This is where FX settlement risk occurs – if the outgoing payment is sent but the incoming payment does not arrive then there is a settlement failure.

To manage this large settlement risk, FX parties can use the new SWIFT gpi financial institution transfer service for MT 202. With this tool, they can monitor both the progress of the payment they sent for the currency they sold, as well as the incoming payment they expect for the currency bought. Whilst this does not take away the risk, it makes a major improvement to the monitoring and management of it. Looking forward, this principle of linking the two payment legs together via gpi could support new PvP-based solutions. For example, if implementing a solution based on an escrow account, funds could be unlocked with certainty following gpi confirmation of credits for each payment leg. To support these new initiatives, we’ll continue to extend the transaction management and data capabilities of our platform.  

Using data to assess settlement exposure

There is also clearly a need for more industry data to understand how the 60% of those FX obligations without PvP protection actually settle, and valuable information on a significant percentage of the $6.6 trillion traded each day is now available. Members of the SWIFT network can now extract information of their own FX confirmations and view them as a dataset. Users can now easily find out their daily counterparty exposure across all their branches, and across their counterparties’ branches too. Privacy and access to these datasets is carefully managed, limiting SWIFT users to viewing their own data, and providing strict control to respect confidentiality and anonymity when viewing it at a market level.

Here, we illustrate how the SWIFT FX dataset can help banks better understand the underlying components of their FX settlement risk, and outline the potential benefits from increasing their use of netting or CLS settlement.

We first created a settlement risk dataset based on: 

(i) FX confirmations sent by a typical top tier bank, for all currency pairs in a 24 hour period;
(ii) for the instrument types spot and swap (the opening leg only) and; 
(iii) excluding confirmations sent between branches of the same firm.

We then calculated the total gross of the buys and sells per currency pair, to give the gross USD equivalent settlement value of all the confirmations in this dataset. When applying netting across all branches, all currencies and all counterparties, we could see that it was possible to achieve an 80% reduction in the gross settlement amount. 

Looking at the BIS report totals this means that settlement risk could hypothetically be reduced by $8 trillion just with bi-lateral netting. Whilst this is a theoretical maximum, we can also see other, more practical, ways to make impressive benefits from netting. 

A typical branch of a top tier bank can have up to 1,000 counterparties, dealing in hundreds of currency pairs. The number of possible combinations would make it impractical to net everything, especially given that banks continue to rely on e-mail to agree the net amount.

We therefore calculated the ideal number of currency pairs and netting counterparties for a branch of a top tier bank, and made the following findings: 

• When netting the top 20 currency pairs across all counterparties, there is a 72% reduction of settlement risk, and 11,000 payments reduce to around 4,000. 
• When netting with the top 20 counterparties across all currency pairs, there is a 40% reduction of settlement risk, and 4,000 payments reduce to 1,000.
• The ideal would be to net the top 20 currency pairs with the top 20 counterparties, as this would cover 26% of all trades, reduce settlement risk by 32%, and reduce 3,600 payments to just 290. 

These illustrative results show that netting not only reduces settlement risk, but can bring many operational and cost benefits due to the substantial reduction in the number of payments. The SWIFT FX dataset is available to any SWIFT user to perform similar settlement risk analysis on their own FX transactions, and we are also ready to undertake customised investigations via our professional services teams.

1. BIS Quarterly Review, December 2019 https://www.bis.org/publ/qtrpdf/r_qt1912.htm
2. BIS Triennial Bank survey https://www.bis.org/statistics/rpfx19.htm