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Tackling FX settlement risk: the power of public-private partnerships
The smooth functioning of cross-border payments is crucial in today’s interconnected world. These payments often involve the settlement of an FX transaction, which requires payment of one currency for receipt of another. A primary risk in such transactions – settlement risk – is that one party delivers the currency it sold but does not receive the currency it bought, resulting in a loss of principal. This risk is heightened by the timing gap between delivery and receipt, as currencies are paid at different times of the day
In October 2020, the Financial Stability Board published the G20 Roadmap for Enhancing Cross-Border Payments, an initiative addressing the challenges of cost, speed, transparency and access in cross-border payments. Building Block 9 of the Roadmap focuses on mitigating FX settlement risk for cross-border payments – a key challenge for the wholesale market – by encouraging the use of payment-versus-payment (PvP) arrangements. The G20 initiative acknowledges that while existing PvP arrangements like those provided by CLSSettlement have made significant progress in reducing settlement risk, there are still obstacles to broader PvP adoption.[1]
The proportion of FX trades not settled on a PvP basis has increased in recent years, driven by the growth in emerging market (EM) currency trading. According to the Bank for International Settlements 2022 Triennial Survey,[2] the share of non-CLS eligible currencies grew from USD0.2 trillion average daily turnover in 2010 (ca. 5.5% of trades) to USD0.7 trillion in 2022 (ca. 8.5% of trades). One way to address the outstanding settlement risk is to make PvP available to a broader range of currencies – particularly heavily traded EM currencies.
Analysis conducted with a subset of CLS settlement members indicated that CLS successfully mitigated around 90% of the settlement risk exposure associated with their FX trades in the 18 CLS-eligible currencies, with full PvP. The challenge to further reduce settlement risk lies primarily in the currencies not currently eligible for CLSSettlement, some of which pose legal and/or geopolitical challenges. For example, adding new currencies to CLSSettlement is a complex endeavor subject to several high hurdles, particularly the satisfaction of crucial legal, risk and liquidity standards in the target jurisdiction. Local authorities – and not CLS – determine the timing and pace of onboarding. Also, a successful onboarding requires broader participation in CLS from both local banks and CLS members across the global FX market, which takes time to cultivate. Any solution to mitigate settlement risk in these currencies will require contributions from both the public and private sectors working in close collaboration to overcome these challenges.
CLS believes that public-private partnerships are the best means to tackle challenges in the FX industry. These partnerships ensure a deep understanding of market needs and help garner sufficient industry investment and support. In fact, CLS was established in 2002 as a response to the public sector’s call for the private sector to address FX settlement risk. Since its inception, CLS has maintained its commitment to public-private collaboration, most recently via its participation in the CPMI-led Payments Interoperability and Extension (PIE) Task Force.
“CLS believes that public-private partnerships are the best means to tackle challenges in the FX industry ”
Shortening the securities settlement cycle to T+1 poses a new obstacle to implementing PvP. This change, taking place in the US and Canada in May 2024, may have implications for the FX trade lifecycle. Asset managers and funds in particular may face difficulties in ensuring timely settlement, as the change could make it more difficult for some of their FX transactions to meet CLS’s cut-off times.
CLS is actively engaging with buy- and sell-side market participants to fully understand the potential impact. A member survey is exploring the feasibility of adjusting CLSSettlement processes to accommodate later cut-off times. The results will inform decision-making and be shared with relevant stakeholders. Any decision will consider client needs in view of CLS’s mission to maintain stability and mitigate risk in the FX market.
CLS has also established a Market Advisory Forum to provide advice and feedback on key market issues that impact the FX industry, including the transition to T+1. The Forum will help market participants understand the challenges arising from a shortened settlement cycle and explore how CLS’s products can assist with the transition in the short term.
Given the projected growth in cross-border transactions, policymakers and market participants must continue to prioritize mitigating FX settlement risk. While this risk has been successfully addressed for CLS-eligible currencies, the challenge remains in achieving broader PvP settlement for heavily traded EM currencies. Addressing this challenge requires close collaboration and active contributions from both public and private sector stakeholders – an approach that CLS fully embraces.
First published in VIEWS: The Eurofi Magazine, February 2024.