Settlement Risk: An Unsolved Problem?

The latest Bank for International Settlements (BIS) Quarterly Report delves into the details around the recent Triennial Survey of FX Turnover, and perhaps one report above others was the most keenly anticipated – that on settlement risk – but has it pushed the matter forward?

Overall, the impression from the report, FX Settlement Risk: An Unsettled Issue, is that the status quo very much remains in place. The headline number in non-PvP (payment-versus-payment) notional terms has gone up, but only as a result of the broader growth witnessed in the Turnover Survey. As a percentage, it is largely where it was in 2019. The paper also finds that pre-settlement netting also went up, but again the percentage of volume netted was unchanged.

In some ways this should not be a surprise, for while there have been initiatives launched over the past three years, the headline act when it comes to PvP is CLS – and CLS has not added a currency to its service in that period, mainly because it is anything but a simple and quick process.

Notwithstanding that, the headline is what grabs the attention, and the paper’s authors calculate it at just under $2.2 trillion per pay, or nearly a third of deliverable FX that is subject to settlement risk. The paper also observes that of $7 trillion deliverable turnover, $5.65 trillion is settled, with $3.5 trillion done so with risk mitigation – just over $2.5 trillion via CLS, $257 billion via other PvP arrangements, and $720 billion via “on-us” settlement with loss protection. Of the $2.2 trillion settled without risk mitigation, $550 million is via “on-us” without loss protection and just over $1.6 trillion via other non-PvP arrangements.

Unsurprisingly perhaps, given this is widely seen as a problem largely related to emerging market currencies, the report finds that more than three-quarters of turnover is smaller jurisdictions is subject to turnover risk, compared to between 20 and 40% in the larger centres. “In general, a smaller share of trades is settled without risk mitigation in advanced economies (AEs) than in emerging market economies (EMEs),” the paper states.

While the paper acknowledges the work of the BIS’ Committee on Payments and Market Infrastructure (CPMI) to highlight the scale of settlement risk, it also acknowledges some of the factors behind the stubbornly-high level of risk. “First is a simple cost-benefit calculus,” the paper states. “Adoption of PvP or similar arrangements requires that market participants find the individual and systemic benefits of using the arrangement to outweigh the costs, which include transaction fees, monthly charges and investments associated with joining the service. Some smaller market participants have indicated that joining existing PvP arrangements, or indirectly accessing their services through a direct participant, is too expensive or not practicable for some trading activities.”

It also observes that non-PvP settlement may be “the only option” for some counterparties, currencies or time zones. It highlights the CHATS system in Hong Kong as an example where offshore Chinese renminbi trades can be settled PvP, but only by participants in Hong Kong, Indonesia, Malaysia, and Thailand.

The report notes that other (un-named) initiatives are underway, as an example, Baton Systems is being used by HSBC for an FX settlement initiative, and also that “incumbents”, we can assume CLS, is looking to add currency pairs – as indeed the service has announced. It closes, however, by noting that “the future of payments may involve the use of multiple central bank digital currencies (CBDCs)” and highlights the work of the BIS Innovation Hub and the New York Innovation Centre in particular.

Overall, it is hard to see this latest report on settlement risk as anything other than an update or appraisal of progress (or lack of it). The settlement area of FX markets is no doubt changing, through various initiatives such as the aforementioned Baton project, work by Finteum, and the growth of CLS Net (although that remains short of a PvP-solution). There is also the factor of FX clearing to take into account, for while slow to develop, there is undoubtedly interest in the clearing of FX swaps.

The fact remains, however, that the FX settlement risk problem is largely the result of the growth in emerging markets trading as investors and traders look for value – and in these jurisdictions there is neither the impetus, incentive and, probably, the will, to overhaul the local market structure.

It is interesting that the report makes a point of closing with CBDCs, the impact of these initiatives (if indeed they come to anything) remains unclear, and that perhaps is a good summary of where the FX market is with settlement risk – very aware and working towards a solution, but understanding that a remedy will take some time to achieve.