By Marc Bayle de Jessé, CEO, CLS
The Bank for International Settlements’ (BIS) Quarterly Review published in December 2019 concluded that FX settlement risk is on the rise due to a significant portion of the global FX market being settled without protection. According to the BIS data, the volume of trades settled with PvP protection decreased from 50 percent in 2013 to 40 percent in 2019. Of note, the data showed that FX settlement risk is growing in currencies not eligible for settlement in CLS. In emerging markets, the settlement risk exposure against the US dollar (USD), and to a lesser extent the euro, equates to approximately the same amount that CLS was built to address when it was created in 2002.
CLS responded to the BIS data with a white paper calling for the FX industry and regulatory community to collaborate to address growing settlement risk. The topic was presented at the Global Foreign Exchange Committee (GFXC) and several local FX committees, and has brought the issue of settlement risk back to the forefront for regulators and market participants alike.
“The amount of FX settlement risk exposure that remains is a prudential exposure bilaterally between counterparties, as well as of systemic concern when aggregated”.
Larry Sweet, Senior Vice President, Federal Reserve Bank of New York
As a global financial market infrastructure, CLS has a responsibility to help market participants understand the impact of settlement risk within the FX ecosystem. To further the debate, I recently chaired a discussion on this topic with representatives from both the public and private sector. Here we share those viewpoints as we look to advance the settlement risk discussion.
According to Larry Sweet1, Senior Vice President, Federal Reserve Bank of New York, settlement risk remains the major source of bilateral exposure and systemic disruption. “The implementation of PvP initiatives led to significant improvements in the industry. However, over time the private and public sector have been monitoring this and unfortunately, notwithstanding the progress that has been achieved, the amount of FX settlement risk exposure that remains is a prudential exposure bilaterally between counterparties, as well as of systemic concern when aggregated.”
“Emerging markets are even more challenging as clients expect the banks to be flexible with regards to gross settlement payments.”
William Shek, Head of FX, EM Rates & Commodities, Debt Trading & Financing, ASP HSBC Global Banking & Markets.
Bill Holmes, Head of Bank and Counterparty Risk, Europe & America, ANZ also highlighted existing settlement risk issues. “Being full on settlement limits has wider implications for our client relationships, not just our bank relationships. As a result, we have negotiated individual net settlement agreements with some of our most active FX trading counterparties, but since they operate on a legal entity basis some of their subsidiaries and our interbank counterparts still remain exposed to this risk.”
Larry supported this assertion by citing anecdotal evidence that suggests firms are not properly managing their settlement risk exposures. Commenting on the prolonged periods of exposure that result from issuing payment instructions well before the settlement date, Larry noted, “The risk of paying and not receiving can begin once you no longer have control of your outgoing payment instructions”. Larry also observed that despite settlement risk exposure being a pure counterparty credit exposure, firms tend not to treat it as such and are willing to tolerate a higher exposure to settlement risk than traditional counterparty risks. This is partly because there typically is no regulatory capital charge placed on settlement risk.
According to Larry, the solution to reducing settlement risk should be managed through a combination of individual trader awareness of the size/duration of exposures and the ability to measure and control it, after which it can be reduced. Larry mentioned that various FX committees have recently focused their attention on settlement risk and are considering individual and collective action to address it. We support these initiatives as we believe settlement risk is best addressed through market re-education about settlement risk exposures and a collective and consistent industry response.
William Shek, Head of FX, EM Rates & Commodities, Debt Trading & Financing, HSBC Global Markets, Asia Pacific agreed with this perspective, noting that in emerging markets client behavior is more likely to change through an industry-wide approach and a broader understanding and recognition of settlement risk. He said, “When we talk to clients, many are aware of the benefits of CLSSettlement, but as they normally receive sufficient settlement limits from banks, they do not have that incentive to change to a new model. However, I believe that settlement risk should be a higher priority because FX volumes in emerging markets are increasing.”
“We have also seen that the enhanced global regulatory framework is pushing more institutions to join CLSSettlement.”
Sandra Laielli van Scherpenzeel, Executive Director / Global Head Cash Banks, UBS Switzerland AG, Corporate & Institutional Clients
Further, according to William, “Emerging markets are even more challenging as clients expect the banks to be flexible with regards to gross settlement payments; if the banks are not flexible enough, it could impact market share because of competition with other dealers.”
The positive news is that there is growth in the CLSSettlement community both through an increase in settlement members as well as through increased third-party access. CLS has seen an annual 6% increase in third-party activity since 2019.
Sandra Laielli van Scherpenzeel, Executive Director / Global Head Cash Banks, UBS Switzerland AG, Corporate & Institutional Clients, highlighted the receptiveness of third-party market participants to better manage settlement risk. “In the last three to five years we have seen an increase in interest among third-party users to join CLSSettlement, which has led to an uptick in volumes. For example, looking at institutional firms such as pension funds, we have seen their investment appetite is changing, and they are looking differently at their returns. As a result, they recognize they need a strong infrastructure which can mitigate the risk that arises from their FX trading activities.”
Sandra added that regulation is leading greater numbers of third-party market participants to acknowledge the importance of PvP settlement. “We have also seen that the enhanced global regulatory framework is pushing more institutions to join CLSSettlement, despite the fact that their own domestic currency is not yet being settled in CLSSettlement.”
Following on from this discussion, I asked Paul Sassieni, Head of Capital Markets and Treasury Credit Risk at Northern Trust, for his views on why there has been a 10% growth in asset managers joining CLS over the past year. He attributed this trend to three key industry drivers: “First, the growth in global investment. In the past funds tended to focus on domestic markets; however more recently they are investing internationally, which has created a tremendous amount of transactional FX activity. Second, there is an increase in third-party FX trading. Previously funds tended to trade FX primarily with their custodian bank. However, as many clients have moved to a multi-dealer model for FX, funds are not necessarily transacting their FX business with their custodian bank where settlement risk is eliminated. Hence over the last few years more trades have become subject to settlement risk. Third is the trend for block trading, where, in the quest for best execution, asset managers conduct a single block trade for a large number of funds they manage. While some of those funds may be clients of a custodian bank, other funds may not, which creates settlement risk.”
CLS convened a panel of representatives from the public and private sector to discuss the rise in settlement risk
“The growth in CLSSettlement is not only being driven by credit risk mitigation, but also the operational efficiencies CLS provides.”
Paul Sassieni, Head of Capital Markets and Treasury Credit Risk at Northern Trust
Paul and Sandra both agreed that third-party membership of CLS is not only being driven by the need for settlement risk mitigation, but also the wider benefits that CLSSettlement delivers. Sandra pointed out the importance of enhanced liquidity and keeping the cost of capital down through the use of services such as CLSSettlement. Indeed, through multilateral netting, CLSSettlement reduces funding costs by 96% and frees up the liquidity the global FX market needs to function effectively.
Paul also pointed out the operational efficiency benefits delivered by CLSSettlement. “The growth in CLSSettlement is not only being driven by credit risk mitigation, but also the operational efficiencies CLS provides through fewer failed trades and cost efficiencies for clients and custodian banks”. Echoing this opinion, Sandra remarked, “The need to improve operational efficiencies has created a strong business case for banks to join CLS”.
On the topic of rising settlement risk in trading non-CLS currencies, Bill said it is the most significant risk ANZ faces. He believes that settlement risk is increasing due to increasing trading activities in non-CLS currencies, particularly in Asia. Adding to this, Bill said, “When trading Asian currencies, you are exposed to a longer time lag between the Asian currency settling and the US dollar settling.”
Bill noted particular challenges with the Chinese Yuan Renminbi (CNH). “Looking specifically at CNH, it is increasingly settling on International Monetary Market dates resulting in tremendous pressure on large banks, particularly those with prime brokerage franchises where activity can increase five-fold on selected days.”
“When trading Asian currencies, you are exposed to a longer time lag between the Asian currency settling and the US dollar settling.”
Bill Holmes, Head of Bank and Counterparty Risk, Europe & America, ANZ
William emphasized other settlement risk challenges in the region. He noted that there can be frequent settlement failures in emerging market currencies, as these the settlement infrastructures for these markets are not as developed or efficient.. “ Settlement failures and risk could be reduced if payments took place on a PvP settlement basis.”
This discussion has highlighted many of the themes that we, at CLS, are discussing as we engage the industry in venues including the GFXC and various local FX committees. It is clear from our stakeholder engagement that the industry recognizes the issue of rising settlement risk and stands ready to address it. In these discussions, we have provided views on a potential settlement risk solution for non-CLS currencies that may involve adjusting the current CLSSettlement model to provide an alternative form of PvP protection. However, we recognize that any new PvP model can only be achieved through close collaboration between the public and private sector – a partnership to which we are wholly committed.
1 The views expressed are the individual’s own and do not necessarily represent the views of the Federal Reserve Bank of New York