GFXD Plots a Path to Accelerated FX Settlement – If Needed
Posted by Colin Lambert. Last updated: August 9, 2023
With The Full FX View
The Global Foreign Exchange Division’s Market Architecture Group (MAG) has published a third study looking at accelerating FX settlement, observing that the market evolution is at an “inflection point…where new processes and new market participants could create opportunities to change how the wholesale FX market operates”.
The latest paper discusses the implications of any change to FX settlement workflows, specifically increased T+0 settlement and more choice about when trades are settled, but it also warns, “It is unclear at this stage if there is the commercial desire for more T+0 activity, given the significant cost implications that market participants must consider, and the associated challenges of achieving scale in a cost and risk efficient manner, whilst reducing the amount of settlement risk within the ecosystem.”
The background to the MAG paper is increased regulatory attention on growing the level of payment vs payment (PvP) settlement in FX markets – something that was kicked off by the Bank for International Settlements in 2019 and has been picked up by the Committee for Payments and Market Infrastructures (CPMI). That said, the paper also highlights the increasing commercial desire to improve process, this reducing operational and settlement risk; as well as interest in deploying new technologies such as central bank digital currencies (CBDCs), tokenisation more generally, and distributed ledger technology (DLT).
The use of new technologies generates practical questions which are yet to be fully considered, the paper observes, not least the challenge of fragmentation. “We believe it is unlikely that a single provider will be adopted by the whole market, which could, for example, increase operational risk and slow the pace of adoption,” the paper states, adding there is also the challenge in a market the size of FX where the number of market participants is vast, and the technical sophistication is varied.
The paper relies upon some key assumptions and requirements for success, some of which are already under consideration by other groups, such as the CPMI. These are the further alignment of central bank RTGS operating hours to allow for more PvP opportunities; the development of an alternative choice of settlement date convention, a standardised global 24-hour period, for example utilising coordinated universal time (UTC); changes to T+0 or to today’s flow of settlement liquidity are expected to be low in volume and agreed on a bilateral basis between counterparties; and a global standard (s) to promote interoperability and integration of technologies.
The paper makes and discusses a series of recommendations – both internally and externally focused – to smooth a transition, should it occur. On technology it sees an opportunity for market participants to develop best practices to ease the transition, the adoption of new trading and settlement processes on a low volume basis (leveraging transactions with high levels of pre- and post-trade automation); and planning for the industry to adopt harmonisation “at scale” when ready.
This means, the paper says, that the transition will be “complicated and ultimately reliant on a wide networked adoption”, therefore the evolution will be “staggered and adopted deliberately on a bilateral, exploratory basis”.
The Full FX View
The GFXD paper effectively highlights what a lot of people are saying in the industry right now – there is a real desire – need even – to deliver safer settlement, but it’s just not that clear how, and if, we can get there.
Perhaps the biggest challenge of any shift will be scale – or more specifically, how many players actually want this change? There is a huge amount of intra-day trading in FX, where the firms concerned want to settle once, at the end of their day, on a netted basis. The paper does indeed note this and the solution does seem to be, as suggested, that different firms use different processes (or net at a certain time(s) on T+0). The question is again, however, will the amount of trades involved – and the value of these trades – be enough to get providers to spend huge sums on changing how they, very efficiently it should be added, currently operate?
The answer must come from the fintech space and here the inevitable fragmentation is less than helpful to the efforts to get change going. There have been times before when competing interests have divided the market and failed to deliver sufficient traction for either, followed by the idea withering away. This is unlikely to happen this time because of the regulatory interest, but it does seem as though a serious economic study of any transition needs to be conducted.
The MAG paper also talks of the need for new FX products to aid funding and settlement, specifically same-day swaps again make a mention. These products can probably be developed cheaper, but we need to have a good idea of the ancillary costs, namely compliance and legal, around new types of transactions.
As things stand, four years on from when the BIS first really highlighted regulatory concerned over the amounts involved in non-PvP settlement in FX, it is hard to see a tremendous amount of progress. There has been a lot of talking at practitioner and regulatory level, but little action.
The fintech world has not been sitting by idly, however, and initiatives do exist – what is needed now is a firm, or preferably a group of firms, to grasp the nettle and back one. By overlaying the recommendations in the GFXD paper, especially around best practice, with a working solution, the FX industry will take a huge step forward and, incidentally, reinforce its reputation for self-regulated innovation.
It seems as though everything is in place – the technology, the desire for change and a good idea of how to execute it – what is needed now is that execution.
The piecemeal approach recommended to settle a T+0 transaction, will see both parties agreeing the mechanism by which it will be settled with finality, and agreeing the timing during the settlement data – batch settlements will likely be preferred initially the paper says. The parties to the transaction will also have to partner with their Nostro bank to ensure funding or the ring-fencing of funds for the settlement, as well as to ensure real-time notification of receipt of funds.
If such a process is to be scaled, the paper says industry messaging systems will have to be updated and new ISO codes shared; Nostro banks and custodians will need to leverage longer RTGS operating hours; and the adoption of new technologies to enable PvP between tokens and fiat currencies.
“It is difficult to predict which technologies will be adopted at scale by the market,” the paper points out. “As such, it is critical to ensure that there are degrees of interoperability between new technologies, new market participants and traditional currency based PvP systems.”
It adds that interoperability will enable market participants to have the flexibility to experiment with their approaches to meet their clients’ needs, rather than being restricted by the functionality offered at a point in time. Harmonisation of standards will also help create opportunities for technical interoperability.
In a neat reversal of the current situation, where the FX industry is scrambling to deliver a solution to the US’ move to T+1 for its securities markets, the paper also says the impact of any changes on other asset classes needs to be considered. It observes that the goal of any new technology aimed at reducing settlement risk should be to enable the simultaneous settlement of both the FX trade and the underlying assets being hedged. It warns, however, that due to the variable levels of sophistication in the market, providers are likely to have to support both legacy and new technologies and their associated processes.
The paper concludes, “Despite the evolution in new technologies and the benefits that these technologies may bring, there are a significant number of challenges for the industry to overcome in order for the volumes of T0 transactions to increase, or for more choice on when wholesale FX transactions settle at scale.
“Whilst some of these challenges have a regulatory angle, the majority are economic and operational in nature. There is also an efficiency challenge, especially given the cross-functional nature of the FX value chain, for example ensuring that communications between divisions and Nostro banks are clear, concise, and timely.”
The full paper can be accessed here.