FX market participants have always prioritised reducing settlement risk and over the years, payment-versus-payment, or PvP, has emerged as one of the best ways of reducing it. Despite generally positive sentiment toward PvP, the proportion of PvP-settled trades has decreased.
Marc Bayle de Jessé, CEO at CLS notes this trend and says that rising EM currency trading is pushing the percentage of PvP settled trades down. “Despite the continued growth in CLSSettlement values, there has been an increase in the turnover of non-PvP settled trades, driven primarily by the increase in trading volumes of emerging market currencies, many of which are not CLS-eligible ,” he says.
Meanwhile Basu Choudhury, Head of Partnerships and Alliances at OSTTRA, points to another reason. “Over the last 10 years, non-bank participation in FX markets has increased greatly in absolute terms,” he says. “Much of this flow does not settle in CLS due to limited access for these participants.”
What other issues exist, preventing the adoption of PvP in FX? And how are solution providers evolving to address them? Let’s dive in.
Barriers to PvP adoption
Rising EM currency flows have long been an issue for PvP adoption. Currently, CLS settles 18 of the largest currencies and these represent 80% of FX trade volumes. The remaining 20% is from where challenges emerge.
Bayle de Jessé explains that bringing a currency into CLSSettlement is a complex effort subject to several factors, given CLS’s systemic importance. “For example, it requires support from the relevant central bank and crucial legal, risk and liquidity standards must be met in the jurisdiction of onboarding. Local authorities also set the agenda and timing for the onboarding of their currency.”
“For that reason, we are now focusing on growing and enhancing CLSNet, our automated bilateral payment netting calculation service. The service helps mitigate risk for emerging market currency trades by supporting market participants in significantly netting down their overall positions, leading to a reduction in the payment obligations exposed to settlement risk while improving operational and liquidity efficiencies.”
He added that recent growth statistics illustrate the scale of the industry’s support for CLSNet. The average daily netted value1 of net calculations in CLSNet consistently exceeded USD120 billion over the last 12 months. Most recently, on 20 June 2024 CLS witnessed a record daily notional of USD593 billion netted in the service.
Kate Weston, VP, Head of Execution, Portfolio Optimisation at Capitolis, says that institutions can leverage a settlement optimization service in such situations where PvP is not available. “This method optimises currency exposure by moving positions across participating banks and optimising each pair simultaneously,” she says.
“In addition, the service enables financial institutions to reduce gross notional and line items to simplify their books, so they can more easily handle a sudden currency shock or crisis.” Weston likens it to purchasing a home insurance policy before something adverse occurs.
“A settlement optimization service looks to reduce exposure ahead of time, providing a unique and vital service by addressing potential settlement risks before they escalate,” she says. “This creates an added layer of protection for the global banking system.”
Choudhury notes that the multilateral service model itself has a few limitations, making it less than ideal for a section of market participants. “Someone, either the service provider or settlement agent, must mitigate against the risk that one or two parties could fail to pay in their obligations,” he says. “This normally involves liquidity backstops and settlement limits and tools to remove exposures.”
He notes that the CLS model also presents a few challenges in terms of cash reserves and central bank access. “The model works for a bank-to-bank flow,” he says, “but where you have an investment manager with a thousand funds, you can’t get away from settling with every single one. The cash needed to service all of that now increases exponentially, making it impractical.”
Jarrad Hubble, CEO of RTGS.global believes two barriers prevent wider adoption. “There are two main barriers for using an existing settlement arrangement: omission of the currency from that service, or the fact that at least one of the sides to the settlement is not using it,” he says.
He explains that these barriers are why RTGS.global believes a new fit-for-purpose common platform is essential. “[An ideal new platform] creates a foundational regulatory framework, designed with accessibility and the potential for a truly global reach in mind, is underpinned by an agile technical infrastructure that leverages the latest standards, payments, message standards, application programming interface (API) and technological advancements, and is overlaid with a comprehensive notification and workflow where finality of settlement is achieved within its rulebook,” he says. In this picture, settlement will be instant, transparent, predictable and executed with certainty of outcome.
“The availability of such a platform across multiple jurisdictions will allow for previously unavailable levels of interoperability whereby currencies can be freely exchanged with peace of mind that local host bank funds are segregated and held at the relevant central banks,” Hubble says. “This will result in the opening up of previously underserved currency corridors — as recently demonstrated with the successful transaction we facilitated with Credo, Humo, Arvand, Alif and Anorbank.”
Choudhury says that the industry needs alternative PvP models, like the OSTTRA bilateral PvP initiative that’s underway right now, to offer flexibility and open it to a wider range of market participants. “You want flexibility in terms of settlement times, whether you’re based out of Singapore or Latin America,” he says. “You also want currency pair settlement flexibility.” When asked to explain more about the latter, Choudhury outlines an example. “You and I could have a Euro-Dollar settlement, but maybe we don’t want to settle that Euro-Dollar,” he explains. “Maybe we want to roll it to the next day or we want to participate in a multi-party liquidity optimization service.”
These kinds of overlays and flexibility are critical to minimising the settlement risk that lies outside of CLS Choudhury feels. Is there anything additional the private sector can do to facilitate increased PvP adoption?
Choudhury says that while industry participants can play a role, new models are the only answer given that the current model is at capacity. “Until we evolve [existing] infrastructure to something new, you’re not going to get to that [ideal] end state,” he says.
Availability of PvP settlement for foreign exchange currency pairs 1,2
1.Adjusted for local and cross-border inter-dealer double-counting, ie “net-net” basis;
daily averages in April. 2 A PvP arrangement is available if a currency pair can be settled by either the B3 Foreign Exchange Clearinghouse (B3) in Brazil, the Clearing Corporation of India Limited’s Forex Settlement (CCIL), the Clearing House Automated Transfer System (CHATS) in Hong Kong or CLS.
What service providers can do
Currently, institutions can access two types of settlement optimisation services for currencies outside the CLS umbrella, Weston says. These are Bilateral Day of Settlement Netting and Multilateral Future Settlement Optimisation.
“A bilateral mechanism allows for the offsetting of payment obligations between a pair of participants across multiple currencies the day the trades are due for settlement,” Weston explains. “The benefit of this service is operational risk reduction and operational efficiency.”
Multilateral Future Settlement Optimization is facilitated as a run with multiple participants looking to optimise for future settlement. “This mechanism moves positions across network participants,” Weston says. “The benefit of this service is future risk reduction while also allowing participants to reduce gross notional and line items to simplify books.”
Market participants can currently access different PvP solutions, all of them based on different models. For instance, some rely on central bank accounts while others work with commercial bank accounts, etc. No matter the model, what market participants want can be boiled down to a few factors.
A good PvP solution must be flexible, transparent, and quick to orchestrate. These factors will help participants use and plan future use of their assets. Choudhury notes that liquidity management and flexibility around settlement times are critical.
“Liquidity optimization tools, similar to compression or rebalancing mechanisms, will be crucial for the growth of and adoption of any broad-based PvP ecosystem,” he says. However, he notes that service providers cannot stop at merely mitigating settlement risk. “Most firms are now grappling with balance sheet constraints due to the introduction of SA-CCR,” he explains. “Any service that can provide further lifecycle benefits for the FX inventory will provide greater benefits for the end customers (IMs, HF, Corporates) and banks.”
Bayle de Jessé agrees and says that PvP settlement must deliver additional efficiency benefits if it is to be adopted more widely in the market. “CLSSettlement is a great example of this as before settlement, it calculates the net funding required of each settlement member on a multilateral netted basis,” he says. “Each settlement member only transfers the net amount of its combined payment obligations in each currency, while still settling the gross value of its instructions.”
As a result, the cash required to settle trades in a given day shrinks considerably. “This makes over 96% of cash flow available for other business operations like trading, sales, and business growth,” he says.
In addition, CLS offers a liquidity management tool to its settlement members – in/out swaps, which, when combined with multilateral netting, results in an average funding requirement of less than 1% of the total value of all trades for participating settlement members.
He added, “Consider our recent record day. On 20 June, CLS settled a record USD19.1 trillion of FX payment instructions. Rather than funding the gross amount to settle their trades, our clients only need to pay the net amount. On this occasion, that was USD380k for every USD100 million settled or 0.38% of the gross value settled. This is only possible due to the unique size, depth and global nature of the CLS network.”
In addition, solving problems at the very beginning is critical. Onboarding is typically a tedious process, given regulatory requirements, and creating as smooth an experience as possible is critical to a service provider’s success.
Choudhury says that standardising legal documents is critical to fast onboarding. “Standard workflows for block, allocations, and netting protocols along with API-based integrations linked to standard protocols like ISO20022, Fix, etc will simplify onboarding,” he says.
Broader access and T+1’s impact
While service provider actions are important, access to PvP arrangements is just as critical. For its part, Bayle de Jessé says CLS supports expanding eligibility to a broader range of market participants, including allowing certain low-risk non-bank participants to directly participate in systemically important FMIs.
“For this to be permitted, changes would need to be made to the Settlement Finality Directive in terms of permitted participants,” he says. “However, any such expansion in participant accessibility should be assessed against the trade-off of potential changes to the ecosystem’s risk profile.”
Wider access to CLSSettlement is already available via CLS settlement member banks that act as third-party service providers. There are more than 35,000 third-party participants including banks, funds, non-bank financial institutions and multinational corporations that access CLSSettlement in this way. In the past five years there has been an increase of 33% in the number of legal entities from around the globe settling through CLSSettlement third-party service providers.
Choudhury feels the point about the risk profile poses the biggest challenge. “With multilateral service, this is difficult as someone, either the operator or the bank intermediaries, must take on the risk that one party does not pay in what they owe,” he says.
Choudhury believes that due to the challenge of risk profiles for multi-lateral services, bilateral models are more practical. “However, the uptake will be facilitated by existing service providers such as custodians, fund administrators, and prime brokers,” he notes. “In the future, the integration of a blockchain deposit account (BDA) into a PvP ecosystem would allow a client to have direct settlement accounts without utilising the bank intermediaries’ balance sheet.”
No talk of settlement risk these days is complete without addressing the T+1 elephant in the room. Val Wotton, DTCC Managing Director, General Manager of Institutional Trade Processing, says cross-border trades will become particularly challenging.
“Foreign investors are only able to determine the actual amount of U.S. dollars to be purchased upon confirmation of the trade,” he says. “At the same time, the FX challenge also creates settlement risk, as foreign investors selling their local currency may not receive the U.S. dollar equivalent to finalise the transaction on time.”
He believes that observing and learning from other markets’ move to T+1 is instructive. “When India moved to T+1 in several phases starting in February 2022, industry participants explored solutions to address the shortened processing window and mandatory pre-funding concerns,” he says.
“While India did not turn into a mandatory pre-funding market post T+1 implementation, what we learned from India’s financial markets is that it is up to foreign investors to work with their intermediaries, including global and local custodians and banks, to agree on the most suitable approach to meet their FX requirements.”
Choudhury sees two outcomes. “The non-US IMs could increase their usage of Synthetic Securities and avoid needing any FX trade to fund the US securities,” he says. “Alternatively, they will likely be forced to outsource their FX execution to the US custodian who is providing the DvP to meet the compressed funding and settlement timelines.”
When asked about its impact on CLSSettlement, Bayle de Jessé said, “Asset manager outreach combined with an analysis of our transaction data indicated that a value equivalent to 0.4% to 0.5% of CLSSettlement ADV could be impacted by the move to T+1 in US Securities.”
As a result, 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 the asset manager outreach, the analysis of CLS transaction data and a settlement member survey. Bayle de Jesse concludes, “While we have not made any operational changes to CLSSettlement, we will continue to work with our clients and the broader ecosystem to explore how we can support the market in the longer term, while always prioritising the stability of the FX ecosystem.”
Expanding PvP settlement
In the short term, not many options seem available to expand PvP access. However, Bayle de Jessé notes that partnerships are always critical. “CLS believes that public-private sector partnerships are the optimal model to solve FX industry challenges such as expanding PvP settlement,” he says, “as it ensures that the market’s needs are truly understood and that initiatives borne out of this collaboration receive sufficient industry investment and support.”
Continuing the theme, Choudhury says that OSTTRA has launched a flexible bilateral PvP settlement orchestration recently. “We are in the process of growing the ecosystem of bank participants and we anticipate that custodians/fund admins and their IMs will look to join as this ecosystem expands,” he notes.
Thanks to moves like these, the long-term picture for PvP remains optimistic, even if short-term adoption lags expectations.