Keith Tippell

The devil is in the detail: shining a light on FX Settlement Risk and what still remains to be done to address the issues

May 2023 in Risk Management

Keith Tippell, Chief Product Officer at CLS Group outlines some of the work being done by CLS and steps it is taking to meet the challenges of FX Settlement Risk.

Has CLS been able to offer further insight on concerns regarding rising settlement risk in the FX market?

International regulators have expressed concern over rising FX settlement risk, especially in emerging market (EM) currencies and other growing segments of the market that lack payment-versus-payment (PvP) arrangements. Despite these concerns, volumes in CLSSettlement have grown steadily, with average daily values settled exceeding USD6.0 trillion. The asset management community, which accesses CLSSettlement indirectly through settlement members, has been a significant contributor to this growth.

To better understand settlement risk, we worked with a subset of our settlement member banks and analyzed their trades to determine how they were settled. This provided a good indication of the market’s management of settlement risk and the range of mechanisms used to settle FX flows.

Our analysis showed that of the FX transactions eligible for CLSSettlement (which comprise 80% of all FX transactions according to the 2022 BIS Survey 1 ), on average 51% of the traded notional is settled through CLSSettlement. Much of the remainder comprises inter-branch and inter-affiliate trades (35%) or trades where settlement occurs via a single currency cashflow or over accounts within the banks’ direct control (together, 8%). This leaves around 6% of trades exposed to settlement risk that could be settled via payment versus-payment (PvP) in CLSSettlement, primarily comprising trades across large numbers of corporates and funds that do not trade in high volume.

How is CLS addressing policy makers’ concerns over settlement risk?

We fully support wider adoption of PvP and applaud the efforts of the Global Foreign Exchange Committee, whose FX Global Code encourages its use, and of the Financial Stability Board, whose Cross-Border Payments Roadmap has a dedicated building block to further PvP adoption.

With regards to CLS-eligible currencies, the 6% of trades that could be settled via PvP in CLSSettlement is the target of ongoing efforts to increase adoption of CLSSettlement.

Addressing settlement risk beyond CLS-eligible currencies may require an alternative solution. As a systemically important financial market infrastructure, adding new currencies to CLSSettlement is an extended effort that is subject to several requirements, including ongoing support from the central banks on both sides of the currency flow, and in some cases changes in the target jurisdiction’s laws and regulations.

Given these complexities, we are exploring several avenues to expand PvP coverage. For now, we are focusing on growing CLSNet, our automated bilateral payment netting calculation service for over 120 currencies to increase efficiencies for EM currencies and help mitigate the risks that can be addressed now. CLSNet may also potentially form the foundation on which subsequent potential new settlement services could operate.

What solution can CLS offer market participants now for addressing rising settlement risk in emerging market currencies?

CLSNet already helps to mitigate risk associated with trading EM currencies. It supports netting to reduce the payment obligations exposed to settlement risk while improving operational and liquidity efficiencies. Crucially, most of the interbank transaction flow through CLSNet is in the deliverable EM currencies that pose the most settlement risk for CLS’s settlement members.

Over the past year, the service has seen a substantial rise in adoption, with the average daily value of net calculations increasing 328% year-on-year during 2022. On 15 March 2023, we witnessed a record daily notional of USD274 billion in net calculations. The growing CLSNet community includes eight of the top ten global banks; latest additions include First Abu Dhabi Bank and UBS, and current onboardings include Deutsche Bank and MUFG Bank.

Successful settlement risk mitigation has been largely achieved for CLS-eligible currencies via CLSSettlement. But with the growth in EM currency trading, the remaining challenge is how to mitigate settlement risk for currencies ineligible for PvP settlement.

For these currencies, mitigating operational risk, optimizing liquidity and creating operational efficiencies through a centralized, standardized and automated process, like CLSNet, is the industry’s preferred approach until a robust alternative PvP solution can be developed.

How is CLS helping the industry through other significant developments?

As the financial market infrastructure in the FX market, we are ideally placed to help market participants solve industry challenges. One of the most recent examples of this is the work we are doing with our settlement members and central counterparties to explore how we can support them in optimizing capital as part of the industry transition to the standardized approach for counterparty credit risk (SA-CCR). Irrespective of whether our settlement members opt for the creation of bilateral overlay trades to flatten their currency deltas, as is currently the case, or opt in the future to centrally clear certain tranches of outright FX trades (such as forwards or swaps), we will play a key role in supporting members as the FX ecosystem evolves.

Our primary focus is to ensure that FX flows are optimally and safely settled, regardless of which method of capital optimization market participants choose. This is an ongoing dialog with the industry that will continue for the next couple years.

Underpinning all our work at CLS is a best-in-class resilience and operational posture to enable us to deliver optimal solutions to public policy and industry challenges. As the critical service provider to the FX market, we require resilience above all else – across our infrastructure, controls and cybersecurity.

We have invested in the technology underpinning our services and now have one of the most sophisticated, resilient, scalable and flexible post-trade technology platforms across global FMIs. It enables us to evolve our post-trade offerings more easily to meet the needs of the FX market, while ensuring we continue to meet the highest levels of operational resilience.

1 2022 Bank for International Settlements survey (BIS Survey);