BoE edges closer on FX settlement risk clarity

When the Bank for International Settlements (BIS) published its first findings on foreign exchange settlement risk in 2019, it raised alarm bells throughout the industry. 

Since then, global regulators and central banks, such as the European Central Bank (ECB), have tried to assess what market participants can do to mitigate the apparent decline in using payment-versus-payment (PvP) settlement systems. But as the data collection was very broad, it wasn’t clear exactly how big a problem it was and where these risks might lie. 

We have rolled out a new version of the data template for FX settlement, which essentially follows a waterfall approach of risks

Philippe Lintern, BoE

To fill in the gaps, the Bank of England’s (BoE) FX Joint Standing Committee (FXJSC) has trialled a new settlement data template alongside its October semi-annual volume survey. 

Philippe Lintern, head of the BoE’s FX division, says the survey will be a comprehensive look at the varying settlement risks banks face today.

“In close collaboration with many industry participants, we have rolled out a new version of the data template for FX settlement, which essentially follows a waterfall approach of risks. Participants will break down all their FX settlement risks starting with PvP settled, then bilaterally netted etcetera, all the way down to gross mitigated and even gross unmitigated,” Lintern tells FX Markets.

The bank plans to share this template with the seven other central bank FX committees, such as those run by the New York Fed and Bank of Japan. This would then be collected by the Global FX Committee (GFXC), which will form a global picture of FX settlement risk, he says. 

Lacking granularity

Previous BIS surveys showed the proportion of volume going through a PvP settlement system shrinking. In its 2022 triennial survey, the global body revealed 31% of daily flows either did not use PvP facilities or used no loss protection in so-called on-us settlement arrangements.

The data is formulated by comparing all of the reported trades to the BIS with trading volumes reported by CLS, the primary FX settlement utility. These findings have led to FX settlement risks being a dominant discussion topic among central banks and market committees. 

However, CLS has previously argued the BIS data does not provide sufficient granularity to make an eligible determination, given the significantly high proportionality of spot FX trades internalised by the banks that do not need to be submitted to CLS.

From that [BIS] survey, it was unclear what the drivers of unmitigated risk were. That’s why we’ve changed to a waterfall risk approach to not only identify the amount that's at risk but why it is at risk

Philippe Lintern, BoE

Earlier this year, it conducted its own analysis of FX trades eligible for CLSSettlement – which comprise 80% of all transactions – where on average 51% of traded notional is settled PvP, while the remainder, it said, comprises inter-branch trades or trades where settlement occurs via a single currency cashflow. CLS said this leaves only around 6% of trades exposed to settlement risk.

Yet the BIS survey scope is wider, and includes both eligible and non-eligible CLS currencies. Given the major rise in emerging markets trading in recent years, particularly the Chinese renminbi, there remains an unclear picture of where the risks are.

“From that [BIS] survey, it was unclear what the drivers of unmitigated risk were. That’s why we've changed to a waterfall risk approach to not only identify the amount that's at risk but why it is at risk,” says Lintern. 

“I think the BIS triennial survey did a very good job of drawing attention to the FX settlement. And the fact that obviously, CLS in 2002 was a revolution for the market and it did a phenomenal job in mitigating Herstatt [FX settlement] risk. But as markets have evolved, some things are falling outside of CLS, and we need to get a clearer view of that.”

T+1 challenges

These risks could become an even bigger focus for global regulators once the US and Canadian securities markets settlement migrates from two days to one day trade after the trade date (T+1) on May 28 next year. FX-related trades that investors use to fund the purchase or sale of these securities will also need to accelerate from T+2 to T+1.

Investors that are not able to do this – such as fund managers operating on different timezones to that of the US – may have to pre-fund the transaction or trade and settle the following day gross on a T+0 basis outside CLS.

Industry working groups have pointed out that Asian-based asset managers will bear the brunt of the move, and have little choice but to settle their FX transactions bilaterally outside of CLS if they cannot trade on a T+0 basis. 

However, Lintern says those affected only represent a significant minority of foreign investors, and is confident the FX industry will deal with the move.

“We’re satisfied that the industry is ready to face up to the challenge,” he says. 

For foreign investors trading US securities, one potential change will be the shift of liquidity to later in the day. 

For example, if a set of securities is traded near the close of the market on a Monday – 16.00 ET for the New York Stock Exchange – this is the point where the exact amount of currency needed to be transacted is known. The FX leg of the trade would then have to be executed, however this period of the day is less liquid with wider spreads. 

But, again, Lintern is positive that the industry will adapt. “If there is increased demand in those hours, we would fully expect the market to respond to that and to provide liquidity in those hours,” he adds.

Codes and practice

The other major themes Lintern is following are the continued fragmentation of the spot FX market and the developments around the FX Global Code.

At the FXJSC meeting in September, attendees discussed the factors around the declining volume share among the two primary spot FX markets – EBS and Refinitiv – as well as the growing importance of the FX futures market in price formation. 

CME dominates the futures market, while the Singapore Exchange (SGX) is also building considerable volumes for Asian-denominated currencies. 

Even though these venues have not yet attained primary market status, Lintern says their development is noteworthy.

“I think some market participants are plugged in to the futures market and straddling both the futures and the spot market. They're very prone to saying that this is the future because they've invested quite heavily in all their infrastructure. Others are slightly more sceptical. I think, certainly, the rise of the futures market is notable and seems like another way to access market liquidity,” he says.

Meanwhile, as the GFXC prepares for the upcoming three-year review of the Code, one area from the previous review Lintern believes requires improvement from liquidity providers is around trading disclosure cover sheets. These set out LPs’ approach to trading, including their last look policies. 

Since December 2021, LPs have been able to upload these disclosure sheets to the GFXC’s website. The majority of the top bank LPs have published a disclosure sheet, however Lintern says the ability to easily access the disclosures, and the level of detail given around last look windows and hold times, varies. 

“The addition of disclosure sheets has been well received. However, our direct outreach to the market shows that quite a few buy-side participants are not aware of their existence. Our own surveys of this shows that they're slightly inconsistent in their qualities, which obviously is something we need to change,” says Lintern.