Regulatory and industry focus in recent years has been on reducing FX settlement risk by broadening the adoption of payment versus payment (PvP) settlement mechanisms which is highlighted in the consultative report by the Bank for International Settlements (BIS) Committee on Payments and Market Infrastructures (CPMI)1 as part of the G20 cross-border payments roadmap.
Well-established PvP arrangements have served the market well for some 20 years, materially reducing overall settlement risk and achieving wide adoption within the scope of the transaction types these arrangements support. However, support is not universal, and as the FX markets have evolved, industry data shows that the proportion and absolute value of transactions ineligible for PvP settlement has increased.
To put this into context, every day there are trillions of dollars worth of FX settlements that are exchanged without any real protection other than an evaluation and acceptance of risk between counterparties. There are two main areas in which new solutions could help to expand access to PvP settlement protection:
The first area is currency coverage. Only 18 currencies are included in the market’s predominant PvP process. The most material gaps are widely traded currencies outside of the traditional majors, such as Turkish lira, Thai baht and Chinese renminbi.
This is significant, especially in light of the Bank for International Settlements’(BIS) 2022 Triennial Survey Preliminary Report2, which found that Chinese renminbi is now the world’s fifth most traded currency. The ability to safely settle additional currencies is an issue which new technology can help the market to address.
The second area relates to increasing the scope of FX market participants that have direct PvP access. For a transaction to qualify for direct PvP settlement, both currencies and both counterparties need to be eligible. For those counterparties that do not qualify, transactions can be PvP settled via a third party service provided by direct members. There are 74 direct members of the most widely used PvP service in the market.
A new approach to an old problem
A report published by the CPMI in July 2022 examined a number of new proposals for PvP solutions (it’s worth mentioning that Baton Systems’ solution was the only live solution of the eleven submissions cited).
Naturally, different solutions have different approaches to PvP. Some rely on central bank accounts, which are not available to all market participants. Baton’s solution is different, in that it can operate using commercial bank accounts, so users don’t need to have a central bank account to access a PvP settlement solution.
This broadens market access and also means that the process of adding the ability to settle additional currencies on a PvP basis can be rolled-out with comparative ease and at an accelerated pace. In some cases, new solutions seek to make use of the tokenisation of currencies in order to effect a PvP settlement. At Baton, however, we rely on already digitised forms of fiat currencies, moving these digital representations across different ledgers and successfully settling these currencies without the need to tokenise.
Some models seek to effect PvP settlement instantaneously, on a gross basis. On the face of it, this is appealing, and Baton, too, offers on-demand PvP settlement in a matter of minutes. However, we enable this for both gross and netted transactions. We believe that netting as many transactions as possible into one payment is a more effective way of not only reducing settlement risk, but also conserving liquidity.
Not only does netting reduce the number and overall notional value of transactions to be settled, but it also reduces payment costs and funding requirements, which can be significant. A 2018 report from Oliver Wyman3 estimated that, for large banks, the annual cost of managing intraday liquidity can be between $100m and $300m. In contrast to multilateral and batch-based PvP settlement processes that may take longer, Baton offers the ability to net on a bilateral basis and settle netted values immediately via PvP.
By offering counterparties the opportunity to settle netted trades on a PvP basis at a time that works
for them and to do so multiple times intraday, users are then able to plan and recycle their liquidity throughout the trading day. The additional functionality offered by new PvP solutions combines fast and efficient settlement with a higher degree of control over what is settled and how often.
What does the market want?
At Baton we are seeing a strong demand for a more nimble and flexible PvP mechanism that complements existing processes. Market participants are looking for a solution which is flexible, dynamic, transparent, easy to schedule and quick to orchestrate. This combination of attributes allows users to make the best use of the financial assets they have at their disposal, to reuse those assets multiple times per day, to plan for the availability of those assets and to react when there is insufficient or excess availability.
By deploying distributed ledger technology (DLT), Baton is able to decentralise the FX settlement process, allowing for more flexibility and for settlement schedules which meet the demands of the participants for the transactions and the currencies in question. We provide the opportunity for banks to render the process more efficient, less risky and less costly on a relatively non-invasive basis.
By integrating with existing systems, we allow our clients to participate in on-demand settlement workflows that transpire across the distributed ledger network that Baton provides. This approach is live and proven and is accessible to a broad universe of wholesale market participants today.
Baton’s Core-FX solution introduced
1. https://www.bis.org/cpmi/publ/d207.pdf?
2. https://www.bis.org/statistics/rpfx22_fx.htm
3.https://www.oliverwyman.com/content/dam/oliver-wyman/v2/publications/2018/june/Intraday%20Liquidity%20Final%20Report.pdf