Completing the FX Settlement Circle
Posted by Colin Lambert. Last updated: November 1, 2021
New firm launches with the intention of filling an important gap in the global FX market’s risk profile
In 2019, the Bank for International Settlements (BIS) surprised many FX market participants by giving over part of its report into its Triennial Survey of Foreign Exchange Turnover to the subject of settlement risk. The BIS noted that in spite of efforts to mitigate settlement risk, over $9 trillion of payments daily remains at risk – largely through being outside of Payment-versus Payment (PvP) mechanisms.
In many ways the FX industry’s surprise was the result of complacency driven by the success of CLS – the bigger players and markets were settling via that mechanism, hence settlement risk had been dramatically reduced. While at face value it had, of course, the BIS report noted that the proportion of FX trades with PvP protection had actually fallen from 50% in 2013, to 40% in 2019. This was largely the result of the growth in trading in emerging markets currencies as investors sought value in a zero-interest developed world.
The momentum from the authorities has not abated, however, the Global Foreign Exchange Committee (GFXC) made settlement risk adjustments a key factor in the latest raft of changes to the FX Global Code, and only weeks ago, the BIS’ Committee on Payments and Market Infrastructure (CPMI) called for ideas to help spread the use of PvP in FX markets.
Against this backdrop, two FX industry veterans have founded Settlement Circle, a new service very much aimed at filling a large part of the gap exposed by the BIS. The co-founders are FX product specialist Declan Clements, who also spent more than 11 years in charge of Standard Chartered’s e-commerce business for the Middle East and Africa; and Julian Gladwin, who also had five years at StanChart before moving to CLS, where he was director of relationship management. Also joining the business, The Full FX understands, is Sue Attwood, former deputy chief dealer at the Bank of England, who most recently spent over 11 years at Logicscope/IHS Markit in customer solutions roles.
Settlement Circle has been deliberately running under the radar as the idea has been developed, however with a proof of concept underway with a bank, it is preparing for a full launch, probably early in 2022. “There remains a challenge for smaller regional banks in getting access to CLS, and of course, that service doesn’t cover a lot of local markets,” observes Gladwin. “We have spent a lot of time talking to people in the industry, helping us build out the original idea behind Settlement Circle, which is to help increase risk mitigation in local markets.
“The challenge for a lot of participants in these markets is that they have to collateralise or pre-fund if they are to access services from CLS banks, and that isn’t fair – it’s certainly not in the spirit of the FX Global Code,” he continues. “We think a Software-as-a-Service (Saas) model can really help these firms access affordable settlement risk mitigation services.”
The key, as far as Settlement Circle is concerned, is extending existing services – with a tweak here and there of course – to local markets, and for that Clements says the firm is blending off-the-shelf solutions with its own IP. “It’s not just about spending money developing a solution,” he says. “We have to bring people with us on the journey by getting the technology, product and service right, if we are to meet their needs. This takes an understanding of treasury processes, liquidity management and, of course, the FX market’s processes.
“As an example, perfectly good confirmation matching and KYC solutions are available off-the-shelf,” he further explains. “To that we can add a service that many banks require, and that is matching the incoming payment with the transaction confirmation – a lot of banks don’t do this currently.”
The Local Markets Challenge
Unlike in the major markets, where players capture 100% of trades are automatically captured from Swift, in local markets few banks exchange Swift confirmations with all of their banks, let alone with local corporates or institutional customers. As Clements notes, the process is anything but seamless and, importantly, there is no automated netting. “A lot of the time two banks are calling each other to agree how many trades they have and it can take time, especially if there is a discrepancy,” he explains. “They then agree the number of trades, any netting if possible, and the final settlement obligation. This process then has to be repeated with the next counterparty, so its onerous and time-consuming.
“Having people on the Settlement Circle service, where we can embed the netting rules they have agreed, and automatically advise them of their settlement obligations, is a real benefit for these markets,” he adds.
Settlement Circle monitors the expected payments from correspondent banks and only instructs the final transfer once both payments have been received. “There is an assumption that if the payment confirmations match, then settlement will happen automatically,” says Clements. “But in reality a lot of banks schedule payments for settlement day but don’t reconcile until the following day – that’s a significant risk that we solve for with automated reconciliation.”
“Settlement risk doesn’t go away because there are a small number of transactions in a particular pair”
To help manage the process, Settlement Circle will build a layer on Symphony, the platform it plans to use for the communications layer that is critical to the service. “If there is something that doesn’t match, we will automatically open a chat with the correspondent bank to highlight the problem, and solve it,” explains Clements.
In major markets, multi-lateral netting and settlement is prevalent, but as Gladwin points out, in many local markets this methodology doesn’t work because there are a lot of unique transactions. “Settlement risk doesn’t go away because there are a small number of transactions in a particular pair,” he observes. “In fact in several markets around, for example, Africa, a lot of trading is in one direction. Netting just isn’t viable, so the scale isn’t there to justify a huge outlay on a solution. This is the problem we are solving.”
Settlement Circle plans to engage at all levels of the FX markets, from central banks to regional players, however it will, the founders stress, be very much focused on meeting the needs of those players at the smaller end that find access to PvP mechanisms difficult.
To do this, it is being built to connect to other services where necessary, however as Clements observes, the core service has to retain its simple concept. “All the local players have to do is send us a confirmation, we don’t want our customers to have to dramatically change their existing processes,” he says. “We do the integration work as necessary – if it’s into RTGS windows or other service providers that’s fine and going forward if distributed ledger technology builds a use case, we can connect into that as well. It’s all about making settlement safer.”
“When you put best practice in place from front-to-back, which is obviously what we are seeking to do, you are changing the dynamics of the market and helping that market develop”
With version 1:0 in the testing stage, Gladwin and Clements stress it is merely the first step on a journey. “The solution will evolve,” Gladwin stresses. “Version 1:0 is a big move in the right direction for local markets, but it will change. It won’t be a ‘big bang’, it will be step-by-step and we will be conscious to ensure our partners and clients are fully onboard for each change.
Although regional players and markets are clearly the target for the firm, there are likely to be benefits for bigger players. Being able to net in local market currencies can give both local, regional and global players a capital benefit and while the numbers may not be enormous, the value that can be derived from being able to trade more in these markets probably far outstrips that in many developed markets. “Netting and reduced settlement risk helps all FX participants,” observes Clements. “They are able to do more trades with their customers while allocating less capital thanks to the reduced risks, so there are plenty of benefits at all levels of the market.”
This is a theme picked up by Gladwin, who points to Mexico as a good example of how reducing settlement risk can help build a country’s market. “The Mexico story is a good one,” he says. “When it first starting talking to CLS it ranked something like 28th in the world by FX volume and was 25th when the deal was signed. As the benefits of PvP were realised it rose to 15 and then into the top 10 – all because of the benefits of settlement risk mitigation.
“When you put best practice in place from front-to-back, which is obviously what we are seeking to do, you are changing the dynamics of the market and helping that market develop,” he adds.
The BIS and the Global Foreign Exchange Committee would probably agree with that statement.