The Last Look…

I have to confess – and sorry to get all technical on you – FX settlement risk is doing my head in! Central banks and similar bodies are endlessly banging on about how the industry needs to do more, but my reading of the latest analysis, from the Bank for International Settlements Quarterly Review, is that the industry is close to doing all it can – and the answer is actually in central banks moving quicker.

Unless you have been in hibernation, you will have read or heard at least one (probably 10) warnings over the amount of FX business that is settled outside of Payment-versus-Payment, otherwise known as PvP – but how much are we talking about and what can actually be done?

Well to answer the first question, according to the BIS analysts, we’re talking 10% of average settlement volume, or $1.416 trillion. It’s a lot, I think we can all agree, and $347 billion of that was PvP-eligible, but look at the reasons given by the BIS for this amount being settled gross-bilaterally. For the PvP-eligible flow, operational reasons were cited, namely missed deadlines, as well as complications around managing credit risk with those banks being used to access the system. Also noted, were the tight payment schedules of a PvP system.

Of the balance, a cheeky $1.069 trillion per day, the analysis provides three broad, and overlapping reasons; no access to a PvP mechanism, no PvP system being available for the currency pair, and the cut-off times for PvP not allowing same-day settlement.

Let’s start with the PvP-eligible flow, because here the industry can do something, and the urgings of the central bankers and bodies like the GFXC are important, and should be heeded. Great efficiency, largely through better technology – which is available – should help solve the majority of the issue. Spend the money to make the post-trade and middle office risk functions more efficient.

On the issue of tight payment schedules, again, if there is time, a more automated process will solve matters, if it is because the deal requires settlement before the cut-off time, that feeds into the third reason for non-PvP cited above – which is where the central banks come in.

I feel that the messaging from the central bank community could be nuanced towards the positive from the ominous

The report recognises that some centres have their own PvP mechanism for the local currency (and sometimes others), but the fact of the matter is that when we talk PvP in FX, we talk CLS, and the latter’s challenges in adding new currencies to the mechanism are well-documented. Alongside this, when looking at non-PvP settlement growth, we have improving access to emerging markets, which is resulting in higher volumes in these pairs, hence the rise in settlement risk, because the PvP mechanism doesn’t exist.

What can the industry do about this? Maybe four years ago I would have had an answer, but, in the absence of CLS suddenly finding a way (and permission from its oversight) to add a host of these currencies, I no longer do so. Why? Well, I had reasonable hopes that the Baton Systems’ mechanism would gain traction, and while it did in a few pockets of the market, it did not do so sufficiently enough for the company to sustain the product, and it pivoted in a different, and more lucrative direction. The mechanism itself still exists in the joint venture with Osttra, but things seem to have gone quiet there. Do we need another initiative like this, or for this to gain more traction? Well, if we are going to solve the $649 billion per day not eligible for CLS problem, I would argue we do.

However…If the industry cannot find it in itself to support a second FX PvP settlement initiative alongside CLS, and if CLS is going to struggle to add currencies, both of which might be the case, then what is to be done? This is where the central banks have to come in – with the various payment and settlement projects being undertaken (and, in defence of the industry, I wonder if this is why a second initiative has not successfully emerged – because it’s collectively waiting for these projects to go live?)

The issue we are dealing with here is not whether an FX trade should be settled in CLS, but the fact that many can’t

I understand that moving quicker is not easy for a central bank; as it is with CLS, the stakes are just too high for a systematic failure, so things have to be done very carefully. That said, I feel that the messaging from the central bank community could be nuanced towards the positive from the ominous. At the moment, we largely hear repeated warnings over settlement risk, but I am starting to think these are becoming counter-productive because too many in the industry just shrug their shoulders or look to the skies.

What is needed, I would suggest, is the more positive and proactive promotion and acceleration of these payment projects that can help solve many of the non-PvP settlement challenges. Not only would this solve the issue of same-day settlement, which is likely to just grow as an issue given accelerated settlement times in securities markets, but it would also be able to embrace the non-CLS currency problem.

Proponents of CLS argue that the new settlement mechanisms miss an important element of the process – netting, and this may well be right, but the issue we are dealing with here is not whether an FX trade should be settled in CLS, but the fact that many can’t – and are unlikely to be able to do so for some time. If a deal cannot be settled PvP because there is no mechanism to support it, or because there are problems with access, surely the best way forward is to push this business towards the new mechanisms? These can sit alongside CLS and sharply reduce the number everyone wants lower, exposed settlement volume.

Part of the problem for the FX industry is that CLS has long been seen as the answer, and don’t get me wrong, it was, and is (and proved itself in 2007/08), a big part of the answer. But to reinforce that point, it is not the only solution to this issue, indeed, given expansion constraints, it probably is not a solution full stop. It does what it does perfectly well, is proven, is the best available solution where available, but it is not available everywhere.

This means, that what can sometimes seem like haranguing of the FX industry over settlement risk should stop, and in its place should come encouragement – encouragement to join the various payment and settlement projects and to help propel them faster, and most importantly, into operation.

We all know there is a settlement risk problem in FX, and it will grow if more non-bank market makers succeed in the market, but I feel the time has come to stop looking at existing solutions, that are doing all they can to mitigate risk levels, and to start actively advancing, and implementing, new frameworks that will help ease matters further.

colin@thefullfx.com