How SWIFT gpi allows FX players to monitor and manage settlement transactions
At the end of 2020 we commissioned an e-Forex magazine supplement on FX settlement risk. Our objective was to bring together some of the leading industry experts to dissect the problem, examine what solutions exist today and see what could be done in the future. At the same time, the Financial Stability Board (FSB) released their Stage 3 report on enhancing cross-border payments. This included a ‘Building Block’ called ‘Facilitating increased adoption of PvP’, which directly addresses the topic of FX settlement risk.
Overview of the focus areas of the FSB Stage 3 roadmap for enhancing cross-border payments
which includes a ‘Building Block’ on ‘Facilitating increased adoption of PvP’
Quantifying settlement risk
CLS currently removes around $5.5 trillion of settlement risk each day, which according to the Bank for International Settlements (BIS) is only a third of the total daily figure. This leaves more than $10 trillion of settlement risk to be removed by other means. BIS also estimates that the proportion of trades with PvP protection appears to have fallen from 50% in 2013, to 40% in 2019. Some underlying reasons for this are:
- the long term upward trend in overall volumes,
- the increasing share of prime brokerage,
- the increasing use of swaps, and
- the trading volumes of non-CLS currency pairs, where the share of emerging market currencies rose to 23% in 2019 from 19% in 2016. CLS currently offers PvP on just 18 currencies.
The increasing use of swaps may well be one of the most significant factors behind this increase in settlement risk. Not only because it has been taken-up by small regional banks that are less likely to use CLS settlement, but also because each swap trade implies four settlement legs.
Using data to understand settlement risk
Clearly, there is a need for more industry data to understand how the 60% of those FX obligations without PvP protection actually settle. Whilst a significant proportion would be via the correspondent banking process, other settlement mechanisms exist such as cross account movements for the “on-us” settlement process or internal account movements for intra-group trades.
The crucial step for FX settlements via the correspondent banking process are the actual payment instructions. Whether settled gross or settled net, each party will send an outgoing payment and will expect to receive an incoming payment too. This is of course the heart of the FX settlement risk – if the outgoing payment is sent but the incoming payment does not arrive, then a settlement failure occurs.
An in-depth survey done by BIS in 2008 estimated that bilateral exposure could exceed a tenth of the size of the institution’s capital for 12% of institutions on a daily average basis, and for 23% of the institutions on a peak day basis. Total settlement exposure across all counterparties for some institutions could be as high as three to six times the size of their capital.
To manage this large settlement risk, FX parties can monitor both the progress of the payment they sent for the currency they sold, as well as the incoming payment they expect for the currency bought, using the new gpi for Financial Institution Transfers tracking service for MT202. Whilst this does not take away the risk, it represents a major improvement to the monitoring and management of it, especially if it users combine the service with bi-lateral netting solutions.
As we look forward to the future, this basic principle of linking the two payment legs together via gpi could support new PvP-based solutions. For example, if a crypto-currency were to become the settlement mechanism for a FX trade, in order to transfer ownership it would still require account links to know when both parties have made their payments. Similarly, when implementing a solution based on an escrow account management arrangement, users would be able to release funds with certainty, knowing they had received gpi confirmation of credits for each payment leg.
To support these new initiatives, we’ll continue to extend the transaction management and data capabilities of our platform. FX settlement risk is an industry critical subject and we hope that the e-Forex supplement we sponsored has helped to contribute to the debate. Conversations and analysis will certainly continue and we look forward to being part of the dialogue.