GFXD Chimes in on FX Settlement Risk

Ever since the Bank for International Settlements (BIS) highlighted the scale of settlement risk in FX markets in its 2019 Triennial Survey of FX Turnover, the subject has moved higher up the industry’s agenda. The FX Global Code lays out clear principles guiding the management of settlement risk and the authorities in the form of the Financial Stability Board (FSB) has continued to drive work forward of creating great efficiency and more automation in the FX payments and settlement work.

Against this background, the Global Foreign Exchange Division (GFXD), the member of which comprise 23 banks active in the inter-dealer FX market, has published a paper with recommendations for reducing settlement risk. The paper reiterates the points previously made by the BIS, Global Foreign Exchange Committee (GFXD) which manages the FX Global Code and has a broader industry spectrum of members, as well as the FSB, and lays out a hierarchy of settlement methods.

These are, at a high level, that settlement netting is preferable to gross settlement, a consistent method is preferable to ad hoc arrangements – in other words, switching between net and gross settlement can increase manual processes.

The GFXD paper focuses on those transactions not covered by automated PvP (payment-versus-payment) mechanisms such as CLS and calls for increased adoption of the FX Global Code, more automation, increased education on currency cut-offs and specific procedures across the full trade lifecycle, and the increased use of standardised practices.

On automation, the paper makes two recommendations, namely enhanced automation in the netting process, arguing the market needs an infrastructure which can support automated messages, such as Swift. “Therefore, it is important that market participants, including custodians can manage those automated tools to support the automation of payment netting as well as splitting,” the paper states, observing that few custodians support he use of Swift or CLS Net.

The paper also discusses the practice of splitting payments into smaller amounts to facilitate more optimal payment liquidity, something that is common in emerging markets. “If known, it would be beneficial to agree with the counterparty and ensure that all parties are aware that a transaction will be settled in smaller individual amounts, rather than the full notional of the transaction,” the paper states, noting that if one party is unaware that payments will be split they are likely to reject and return the unexpected payment amounts.

The paper also notes that greater awareness of currency cut-off times – generally speaking these are dictated by the operating hours of a local central banks – would reduce settlement risk, especially if amendments were requested after the cut-off time. Thus, the paper says, the recommendation is that Internal procedural cut-off times are clearly communicated across all internal stakeholders involved in the life cycle of a transaction, including counterparty on-boarding, sales/trading, treasury/funding functions, and post-trade functions. “This improves transparency and the potential impact of increased settlement risk,” the paper says, adding that consideration should be made for both incoming and outgoing payments when reviewing relative cut-off times as these may vary by currency.

As is the case with the FX Global Code, the paper recommends the use of standardised settlement instructions (SSIs) and says these should be agreed during the on-boarding of a client – settlement to non-standing instructions is “strongly discouraged”.

The increased standardisation of procedures and increased communication as to the exceptions to these procedures remain key mitigants of settlement risk.

The format when communicating either initial SSIs, changes to SSIs or changes to non-standing instructions should follow standardised industry templates and communicated via industry defined authenticated methods,” the paper further recommends. This will enable automated communication and uploading and avoid manual intervention which can increase settlement risk, it adds.

Equally, the use of third-party settlement instructions (any payment to a counterparty that differs in any way from the name of the entity traded with, including subsidiary and affiliate accounts) should be minimised, and if they are to be used then sufficient evidence (to be agreed between the parties) should be provided to support the purpose of payment.

Even though there is currently inconsistency in the market, the inclusion of SSIs on trade confirmations could help reduce settlement risk by enhancing automation, GFXD says in the paper, however, to facilitate automation, market participants should be able to amend the standards through ISDA agreements or on the confirmation platforms themselves before the market can achieve a standardised approach on the inclusion of SSIs on trade confirmation.

Finally the paper says it is paramount that market participants use authenticated means to communicate settlement instructions between parties and avoid reliance on unauthenticated tools such as emails in order to reduce the risk of fraudulent activities. “In line with this objective, we encourage vendor platforms to adopt a standardised approach and share SSIs with their counterparties,” the paper states.

Acknowledging that in spite of the recommendations in the paper reducing settlement risk, there are still likely to be occasions when errors are made, the paper also calls for a more harmonised approach to remediation, noting that at the moment these are proprietary in nature across various institutions. It also points out that payment recall or “kickback” processes can take several days, meaning organisations are open to settlement risk, and recommends that these processes should be prioritised and take no longer than five days. It adds that any jurisdictional differences for kick back processes should be aligned.

“Managing and reducing settlement risk remains an inherent part of the global FX market,” the paper concludes. “Whilst automation offers opportunities to reduce settlement risk, the global nature of the market, the varied level of sophistication of the organisations using FX and the varied reasons organisations need to trade FX mean that increased standardisation of procedures and increased communication as to the exceptions to these procedures remain key mitigants.”