From serving retail and corporate businesses to maximising yield, the FX wholesale industry is fundamental to the functioning of global markets. However, it’s under growing pressure to reduce trade and post-trade costs. At the same time, the industry and regulators continue to seek to eliminate settlement and counterparty risks. Scrutiny from policy makers is growing, while international bodies like the G20 and FSB are ramping up the monitoring of FX risks.
Payment-versus-payment (PvP) settlement plays a critical role in reducing settlement risk. But although PvP settlement is increasing, there is still a significant proportion of FX transactions that are not being settled PvP, particularly in emerging market currencies. For this reason, the Committee on Payments and Market Infrastructures (CPMI) has begun working with the industry to accelerate risk reducing PvP arrangements.
Let’s take a closer look at the reasons for non-PvP settlement, and the technical challenges the industry needs to address in order to increase PvP protection across currency pairs.
What’s driving non-PvP settlement?
There are a number of reasons why deliverable FX trades continue to be settled without a PvP mechanism. For one thing, demand for emerging market currencies that lack PvP protection continues to increase, not least because of the strong appetite for goods and commodities from emerging markets. Indeed, the percentage of emerging market currencies in total daily average FX turnover in April 2022 was 17.8%, according to 2022 BIS triennial preliminary report1.
Another factor is the current market structure, whereby PvP arrangements are not available across all currencies, or accessible to all players. CLS, the main scale PvP provider, has been focusing on expanding eligible currencies in recent years, and the 18 most traded currencies benefit from PvP protection where settlement occurs in central bank money. Because expanding the number of eligible currencies is not a trivial exercise, the alternative option is to use CLSNet, a bilateral netting calculation service across 120 currencies that has seen significant adoption in recent years.
Alternative solutions are also emerging, with a number of fintechs looking to offer PvP, including for emerging markets currencies. By nature, these solutions tend to start small and focus on specific use cases without being subject to high levels of regulatory scrutiny. As such, it could be some time before they reach a significant scale – and at some point along that growth journey, greater regulatory scrutiny will require them to demonstrate that they have the resilience and mechanisms needed to be part of a stable financial ecosystem. Nonetheless, innovation and new entrants may yet have an important role to play in bringing new PvP arrangements to the market.
Harnessing existing developments
Meanwhile, more investment is needed in payments in order to optimise the benefits of other recent developments. PvP is needed because it addresses the lack of certainty over counterparties’ actions – but there have also been developments within the industry that increase visibility over payments in other ways. In particular, the industry has been maximising the use of the correspondent banking network in recent years, with global transaction banks and their intermediaries investing in collaborative solutions.
These solutions have an important role to play in increasing end-toend transparency and visibility over the settlement of payments, including FX-related payments. Swift gpi, for example, provides real-time information on the status of a payment throughout the chain of participants, with a service level agreement (SLA) that fosters faster processing and payment confirmation.
Swift gpi has seen great momentum and has been adopted in 211 countries with up to 90% of customer credit transfers confirmed when they reach the end beneficiary. Once any remaining beneficiary banks and RTGS systems adopt Swift gpi as well, the industry will benefit from full visibility and transparency over FX settlements, further mitigating risks and reducing the complexity of liquidity management and forecasting.
Technical challenges hindering PvP
Alongside the issue of adoption, PvP providers also need to address a number of technical challenges and regulatory hurdles. A recent consultative report by CPMI2 explored the causes of non-PvP settlement and the roles that the private and public sectors could play in facilitating adoption. The report also discussed barriers to PvP, including the lack of strong incentives to comply with BCBS Guidance and the FX Global Code. Other obstacles included the disparate operating hours of local RTGSs, as well as inconsistencies in the legal definition of settlement finality across different jurisdictions.
The industry has been looking at ways to address these challenges using mechanisms such as earmarking and pre-funding, which provide some certainty on the settlement process. However, these methods need to be balanced against liquidity needs – particularly in the current market, in which access to liquidity is tighter and interest rates are rising. Optimising the use of liquidity is increasingly critical for our users, and as such the right balance needs to be struck between the cost of liquidity, settlement finality, and protection against potential risks.
Initiatives to interlink RTGS systems have the potential to remove the risks that can arise from multiple counterparties and mitigate some element of FX settlement risk. However, there are currently few live arrangements in place, partly due to the operational challenges involved in aligning the procedures and operating hours of different schemes.
Interoperability and collaboration
CPMI has achieved much in creating an industry dialogue on the importance of PvP. But one point that should not be overlooked is the need to ensure the interoperability of new solutions. Players like CLS, the correspondent banking network, emerging fintech solutions and enablers like Swift will all have a role to play in mitigating settlement risk and improving transparency. However, as new solutions emerge, it is important to ensure that the very initiatives designed to reduce risk do not introduce even greater risks by creating fragmentation and introducing platforms that do not talk to each other.
Any new solutions that emerge should be natively interoperable and future-proof, in the context of the greater interlinking of RTGS systems, and the ongoing exploration of digital currencies.
In conclusion, much has been achieved in the last 20 years in driving more standardisation, automation, interconnectedness, speed and transparency. While these benefits are tangible, risks and frictions remain, amplified by growing volumes and volatility, and especially for non-PvP protected currencies.
There is still room for further synergies to be achieved through greater industry collaboration – particularly in a financial industry where more budget is currently spent on regulatory compliance than on innovation. By leveraging existing investments, while also channelling new investments, there’s an opportunity to develop interoperable, future-proof solutions in those currencies where risk reduction is needed the most.