FX settlement exposure is an important consideration not just in FX but across the global financial system. The 2022 BIS triennial survey found that almost one-third of deliverable FX turnover ($2.2 trillion) was subject to settlement risk, up from $1.9 trillion in 2019.
CLS, as the leading market infrastructure mitigating FX settlement risk through the provision of PvP settlement, has conducted an analysis of its settlement member data to shed some light on the matter. The analysis found that around 90% of the settlement risk exposure associated with their FX trades in the 18 CLS-eligible currencies was successfully mitigated via CLSSettlement with full PvP.
As a result, it is widely accepted that the increase in settlement risk is due to an increase in currencies ineligible for payment versus payment settlement, such as heavily traded emerging market currencies, as a share of overall FX turnover. According to the BIS 2022 Triennial Survey, the growth in turnover of emerging market currencies has increased from USD0.2 trillion in 2010 (ca. 5.5% of trades) to USD0.7 trillion (ca. 8.5% of trades) in 2022.
The BIS also acknowledged that although existing netting and payment-versus-payment or PvP mechanisms help to mitigate settlement risk, they do not fully eliminate it – because existing PvP arrangements are at times unavailable or unsuitable for some trades. The rationale for increasing PvP arrangements is one of the key topics we will focus on in this supplement.
The BIS Markets Committee has referred to the importance of strengthening FX settlement data integrity and consistency and promoting market-based solutions to mitigate risk. Technology will obviously play a vital role in this process and that is another topic we explore in detail.
A note on the Single Supervisory Mechanism published by the ECB last year stated that FX settlement frameworks need enhancement and specifically referred to incomplete reporting and fragmented information systems that do not facilitate capturing of full FX settlement exposure.
The significance of the work being done by the Global Foreign Exchange Committee (GFXC) is referenced in our market perspectives article alongside the specific challenges posed by the move to T+1 securities settlement in the US.
In a submission into the review of the FX Global Code published earlier this year, the BIS Markets Committee recommended that the GFXC should continue its work on reducing FX settlement risk and described the 2021 amendments to the code that emphasised the use of PvP settlement mechanisms where possible and discouraging ‘strategic fails’ as a useful first step.
CLS has done – and will continue to do – valuable work in this area. Demand for CLSSettlement has risen steadily in the past few years and over the last 12 months in particular there has been increased engagement from third parties including banks, funds, non-bank financials and corporates.
Given that adding new currencies to CLSSettlement is a complex process, CLS is currently focusing on the development of its CLSNet platform, a standardised, automated bilateral payment netting calculation service across 120 currencies. This service facilitates the reduction of payment obligations exposed to settlement risk while improving operational and liquidity efficiencies, particularly for emerging market currencies not eligible for CLSSettlement (for example, trade instructions including CNH represented approximately 40% of the total notional value of net calculations in CLSNet during the second half of 2023).
It is important to recognise the significance of initiatives such as the G20 cross border roadmap and the strengthening of the settlement risk principles of the FX Global Code in building on industry momentum to further mitigate settlement risk.
We hope you find the content of this supplement stimulating and as always welcome your feedback.