#### Need to know

• The BIS’s latest triennial FX survey showed the proportion of trades going through payment-versus-payment (PvP) settlement systems fell to 40% from 50% in 2013.
• The fall is blamed largely on growth in trading of currencies not eligible for CLS.
• But in CLS-eligible currencies, only a third of BIS trading volume had PvP protection.
• Regulators and market infrastructures are making a new push to obtain data to work out the exact causes.
• But some believe the risk may be overstated – for instance, the growth of internalisation may artificially increase the gap between traded volume and CLS settlement volumes.

Ever since Bank Herstatt left counterparties in the lurch in 1974 by going bust in the middle of a foreign exchange trade, having received Deutschmarks from counterparties but not paid out its US dollar legs, settlement risk has been recognised as one of the most important facing the FX market.

But it’s a nebulous risk that has been tricky to measure: data did not exist to quantify the amount of it in the system, and banks were not required to track it.

So, when the Bank for International Settlements (BIS) presented the results of the first industry survey on settlement risk in December 2019, it took many by surprise: the proportion of volume going through a payment-versus-payment (PvP) settlement system had fallen to 40%, from 50% in 2013. Another study by CLS showed that in currencies eligible for the service, only a third of trades in the BIS study had PvP protection.

The results raised eyebrows across the market when they landed: “CLS was created to try to eliminate settlement risk, but when you see a headline that only one third of executions are going through there then we have a bit of an issue,” says the global head of e-FX at one liquidity provider (LP).

Since then, the topic has been high on the agenda of meetings by the Global Foreign Exchange Committee (GFXC), and the various central bank FX working groups, as they try to work out why this risk seems to be rising faster than it should be given the growth of the market.

The growth of trading in emerging markets currencies is highlighted as one of the key reasons for the rise in settlement risk. While trading in these currencies grew significantly between the 2016 and 2019 BIS triennial surveys, many do not meet the criteria for CLS’s multilateral settlement service, CLSSettlement.

“Although most of these currencies are not a big part of the market in terms of volumes, you have pairs like USD/CNH which have become much more actively traded recently,” says the global head of e-FX. “And so, while this doesn’t explain the full gap, CLS not covering EM currencies is playing a big part.”

###### The FX market dodged the financial crisis reforms, so it’s always been much more difficult to get under the hood of the FX market than the interest rate market
A source at one international regulatory body

CLS is considering adding a stripped-back service for these currencies, but netting benefits will be more limited, while others suggest changes to the operating hours of real-time gross settlement (RTGS) systems of these non-CLS currencies could help in the meantime.

More puzzling is the growth in G10 trades that are eligible to settle at CLS but don’t. CLS data shows roughly 38% of G10 FX trades may be eligible for CLSSettlement but do not currently settle with CLS.

Some believe the growth of non-bank market-makers could help explain the issue, while others believe the risk might be overstated by changes in trading practices.

However, there is also a suggestion that, as costs to settle trades can outweigh the penalties for settlement fails, there is little incentive for market participants to use settlement systems – something the GFXC sees as a potential conduct issue.

### Seeking better clues

The main way to tackle settlement risk is through payment-versus-payment systems of the type operated by CLSSettlement. In these, each counterparty pays the currency being sold and only pays out the bought currency if the sold currency is received.

Use of this service has never been particularly well understood, however. Regulators never required banks to report settlement data, so they never needed to capture it. Last year’s BIS survey was the first to include a question on such data.

The answers created a stir. Daily FX trading of $6.6 trillion was resulting in gross payment obligations of$18.7 trillion, which netted down to $15.2 trillion. Of this, only$6.3 trillion was settled using PvP through CLS or similar systems – around 40%, down from 50% in 2013.

For regulators and central bankers, this sparked a new push to collect more data to work out where this risk is coming from.

“The FX market dodged the financial crisis reforms, so it’s always been much more difficult to get under the hood of the FX market than the interest rate market, for example. A lot of work is currently under way to better understand what’s causing this increased settlement risk by collecting more data on it,” says a source at one international regulatory body.

Alongside the BIS asking more questions about settlement risk in its next triennial survey, local FX committees are starting to include more data on settlement risk in their bi-annual surveys in order to better illuminate its extent within the market.

According to the source at the international regulatory body, this should provide much more granular data on the geographic regions and specific market participants that are creating the most settlement risk.

“At the moment, we’re unable to dive into the data to find out which regions or market participants are a particular cause for concern, so hopefully when we run our survey again we’ll better know where we should be focusing our attention – whether that be bank or non-bank counterparties or specific currencies,” he says.

### Emerging markets in the frame

Based on the data that is already available, the growth of emerging market currencies not currently included within CLSSettlement is cited as one of the key drivers of increasing settlement risk.

To be part of CLSSettlement, currencies need to meet a number of key eligibility criteria, many of which are set out in the Committee on Payments and Market Infrastructures (CPMI)-International Organization of Securities Commissions principles for financial market infrastructures. In addition to domestic support for settling the currency at CLS, the country needs a minimum credit rating of BB- at S&P and Fitch, or Ba3 at Moody’s.

The required domestic legislation must support finality of settlement of payment instructions at CLS, and finality of funding to and from CLS’s account with the central bank. On a wider scale, there needs to be what CLS describes as “acceptable rule of law”, and an acceptable anti-money laundering regime. The currency needs to be convertible, with no exchange controls, and its RTGS system needs to meet certain requirements.

Chile is hoping its peso will become the nineteenth currency in CLSSettlement in the next 18 months and is in the midst of making the legal changes that would help it meet the criteria.

“We are currently working with the Central bank of Chile to assess the onboarding of the peso, which would be the first South American currency included in CLSSettlement,” says Marc Bayle de Jessé, chief executive of CLS

Many countries are unable to meet the criteria, however, and volumes are growing. Trades in which a CLS-ineligible currency is on at least one side of the trade currently equates to approximately $1.25 trillion – a 35% increase since the BIS 2016 triennial survey, when it sat at around$930 billion.

###### We’re encouraging PvP settlement through whatever mechanism possible. It doesn’t have to be CLS
Guy Debelle, Global Foreign Exchange Committee

According to the BIS survey, increased trading in the most active non-CLS EM currencies between 2016 and 2019 was in the Chinese renminbi (+43%), Taiwanese dollar (+44%), Indian rupee (+50%), Indonesian rupiah (+102%) and Philippine peso (+103%).

But Guy Debelle, chair of the GFXC and deputy governor of the Reserve Bank of Australia, points out that the full extent of settlement risk in emerging markets currencies is hard to get a handle on.

Speaking on a GFXC press call on September 25, Debelle said some emerging markets currencies have their own onshore systems to reduce settlement risk outside the involvement of CLS, such as in India. Therefore, the growth of CLS-ineligible currencies in the BIS survey might not quite capture the whole picture.

“While emerging market currencies not in CLS have the highest share of global turnover, emerging markets currencies do have other onshore means of settling those currencies, so the issue doesn’t quite boil down to the fact that they’re not in CLS and therefore they’re not settled. That’s one of the things we’re trying to get a handle on within the GFXC and the local FX committees,” said Debelle.

Nevertheless, the GFXC is encouraging market participants to settle their trades using whatever means are available to them – whether that means CLS or not.

“We’re certainly not promoting one solution only,” said Debelle. “We’re encouraging PvP settlement through whatever mechanism possible. It doesn’t have to be CLS. We’re agnostic about what the actual solution is, but we very much encourage people to use a solution if it’s out there.”

The increased adoption of PvP has support at the political level too. The G20 has made enhancing cross-border payments a priority during the 2020 Saudi Arabian presidency – the idea being that faster, cheaper cross-border payment services help support international growth and trade.

A CPMI report to the G20, published in July, set out a series of building blocks to achieve this goal. One of them was the increased adoption of PvP to reduce settlement risk, which it says would help facilitate cross-border payments.

With all that in mind, CLS is considering the creation of a second-tier settlement system for currencies that are not currently eligible for its main service, in a bid to encourage a wider adoption of PvP settlement methods.

“If settlement risk in non-CLS currencies is to be mitigated, a fundamental consideration is whether an alternative model that provides a form of PvP protection is better than the outright risk that is taken today in trading these currency pairs,” says de Jessé.

One of the features of CLSSettlement is its multilateral netting service, which takes all the 18 eligible currencies and nets down payments across all pairs to lower the eventual settlement amount. Its proposed second-tier settlement service would allow emerging market currency netting to be done only on a single-pair basis, which would reduce netting benefits from 96% under CLSSettlement to as low as 60%.

For some, though, having anything there to reduce credit risk is better than nothing.

“If CLS was able to do something quicker around those currencies, that would reduce a lot of pain for the market and we would certainly be interested in seeing non-CLS currencies becoming part of the system somehow,” says an operations head at one large dealer.

Policy-makers and central banks could also have a role to play. A source at a second international regulatory body says they could encourage overlaps between the operating hours of the emerging market and CLS currency central banks’ RTGS systems, so that timing lags between currencies outside of CLS is less of an issue.

The next step would be to link up two or more systems to make sure settlement can actually happen on a PvP basis, but the source acknowledges it would take time and resources to get there.

### Other suspects

The data shows it’s not just the growth of CLS-ineligible currencies that is creating the increase in settlement risk. A significant percentage of trades within CLS-eligible G10 currencies are also increasingly settled without PvP protection.

According to a recent report from CLS, the total volume of CLS-eligible currencies is \$5.34 trillion, of which around 31% is settled by the service. Another 31% is related to categories that don’t require PvP settlement: so-called related party trades, which are trades between two legal entities of the same global bank; and trades that have been given up to prime brokers.

The remaining 38% of FX trades eligible for CLSSettlement do not currently settle with CLS – with this figure growing by 17% between 2013 and 2019.

The source at the regulatory body says merely capturing more of this trade set that is already eligible for CLS could make a big difference to settlement risk: “There’s a huge amount of improvement you can do on settlement risk even before you start thinking about exotic currencies.”

The source believes one reason for the declining use of PvP for G10 currencies could be the increased importance to the FX market of non-bank market-makers, which currently lack access to CLSSettlement as a direct member. However, he admits that the lack of data on settlement risk prevents the industry from gauging the extent to which this idea holds true.

“I don’t know the answer at the moment, because I – and others – don’t know what’s underlying the cause of this increased risk. Once we understand that, we can start to design the possible fix,” he says.

###### We are conducting a deep dive with a settlement member to better understand why some trades are not sent for PvP settlement and whether this increases settlement risk
Marc Bayle de Jessé, CLS

While criteria for direct membership is strict, CLS’s de Jessé says third-party access – where end-users access CLSSettlement via a direct member – is on the rise.

“Third-party growth has been a priority for us, and we have seen nearly 6% growth in third-party settled values over the last year. We have been raising awareness of FX settlement risk among the wider FX community – asset managers, regional banks and corporates – ensuring it’s clear what exposures they currently face and how we could potentially provide them with a solution,” he says.

Another potential root cause of settlement risk under discussion at the GFXC is simply mathematical. As the costs involved in settling a trade sometimes outweigh the penalty of failing to settle, market participants might choose not to settle their trades in order to save money in an increasingly competitive and lucrative market.

“What we’re trying to articulate within the global code are principles of good behaviour, which may go against what is the best profit-maximisation decision in the market. Those two things can often be in conflict with one another, so what we’re trying to remind people is that we expect them to be pursuing the appropriate conduct,” said the GFXC’s Debelle.

Some senior market officials, however, believe the decreasing proportion of G10 trades settled in CLS could be explained by the growing practice from large LPs of offsetting client FX spot trades internally before going out to hedge in the external markets, known as internalisation.

If these trades are settled on the books of the LP, then the firm will put only the net of its trading into CLS. But the BIS turnover data only records gross trading, which creates an artificial gap between the two figures.

Although the current BIS data doesn’t provide enough granularity to know for sure why more trades aren’t coming through to CLS, the service is currently conducting its own analysis with one direct member in an attempt to see which trades are not coming through to the system, and understand why that might be. The analysis is expected to be completed before the end of the year.

“We are conducting a deep dive with a settlement member to better understand why some trades are not sent for PvP settlement and whether this increases settlement risk. And, if so, how we can ensure all eligible trades are settled via CLS to mitigate this risk,” says de Jessé.

The CLS report also calls on market participants to “evaluate existing operations and identify which transactions are and are not settling via PvP, and for what reason”.

While the industry continues to grapple with the root causes of settlement risk before it can start tackling and reducing it, one solution provided by the GFXC will see the current language on settlement risk strengthened within the global code as part of its three-year review.

Principle 35 of the code deals with settlement risk and states that market participants “should take prudent measures to manage and reduce their settlement risks, including prompt resolution measures to minimise disruption to trading activities”.

“At the GFXC we’re mostly in the business of just reminding people that settlement risk is a thing, so we’re looking to strengthen some of the text on settlement risk within the code,” said Debelle, adding that the body hopes to have agreed language on the table in time for its December meeting.

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