High finance – it sounds tricky. And when your firm is walking the high wire of complex, sophisticated risk, landing safely is a skill. According to industry insights, more than half of the world’s cross-border transactions take place without an adequate safety net.
Real-time liquidity management and real-time settlement are critical components in navigating the complexities of FX settlement risk. Here’s what’s at stake.
The size of the challenge
The Bank of International Settlements (BIS) shone a light on the size of the problem. There is evidence within its report of an escalating challenge, fuelled partly by the growing volume of emerging market FX:
“FX settlement risk, the risk that one party to a currency trade fails to deliver the currency owed, can result in significant losses, and undermine financial stability. Netting and payment versus payment (PvP) mechanisms help to mitigate this risk. However, almost a third of deliverable FX turnover, or $2.2 trillion, was still at risk on any given day in April 2022, up from $1.9 trillion in April 2019.” –Marc Glowka & Thomas Nilsson, BIS Quarterly Review 2022
The FX market landscape
The foreign exchange (FX) market is referred to as the oil or fuel of the wholesale, interbank world. And like oil production, there are other associated costs in the FX market – spreads, slippage, margin, fees, credit usage and such like – that must be managed and mitigated effectively.
A significant portion of the movement of wholesale money internationally averages one to two days. This is despite major innovations that have improved the efficiency of high-value domestic payment systems and allowed for smoother transactions within a single jurisdiction. Many of these transactions are conducted using legacy infrastructure, processes, and systems that are not operational 24/7.
Rewards and risks
The G20 Roadmap for Enhancing Cross-Border Payments, an initiative addressing the issues of cost, speed, transparency, and access in cross-border payments, was published by the Financial Stability Board in October 2020. Building Block 9 of the roadmap says that Payment-versus-Payment (PvP) agreements help to reduce FX settlement risk for cross-border payments.
PvP ensures simultaneous payment for both sides of a transaction, effectively eliminating settlement risk and reducing friction. Nick Miles from RTGS.global says:
“Opting for PVP ensures immediate clarity in transactions, eliminating uncertainty. Unlike traditional models with intermediaries, bilateral dealings enhance transparency, offering a clear view of the payment chain.”
This is especially crucial in emerging markets dealing with various currencies, where reliance on a network of trusted partners becomes paramount.
One note of caution is that while reducing settlement risk is beneficial for market stability, it can amplify liquidity risk due to increased trading activity and the corresponding demand for liquidity.
Meanwhile, central banks and other private and public sector players are working together to promote a wider use of PvP. The Global Foreign Exchange Committee (GFXC), which is made up of central banks and market players, leads a regular review and update of the Code, with the next review about to begin in 2024.
“Looking ahead, an important GFXC priority is FX settlement risk. Given the size of the FX market, the implications of one party failing to deliver to another can be significant and systemic.” —Anna Nordstrom, Head of the Domestic and International Markets Functions, Federal Reserve, October 2023
Shift to real-time liquidity management
The foreign exchange (FX) market witnessed a notable shift after the introduction of real-time gross settlement systems (RTGS), reflecting a broader trend towards real-time liquidity management. This evolution underscores the growing demand for innovative solutions to streamline and manage FX activities, with industry leaders like Fnality, Finteum, RTGS.global, Baton, and Planixs setting the pace. Nick from RTGS.global says,
“The world is becoming more real time. When you pay in domestic currency to domestic currency, that happens instantly. I appreciate that with FX we’re talking about cross-border payments, but the mechanisms aren’t that different. It’s about the regulation, the legal framework, the settlement finality. If I source a currency, I need absolute assurance that I can then use that for onward domestic payments.”
Next-generation Financial Market Infrastructure (FMI) facilitates PvP settlement for nearly any currency corridor, supported by essential financial market utilities such as CLS (Continuous Linked Settlement). It enables atomic bilateral settlement between commercial and central banks, leveraging real-time liquidity availability. This infrastructure is underpinned by ringfenced central bank reserves allocated to the global payments network, ensuring the smooth operation and security of financial transactions.
While liquidity managers traditionally favoured stability over quick movements, the proliferation of over 60 instant domestic payment systems, with the majority operating 24/7, reflects the growing trend towards real-time transactions.
By monitoring PvP settlements in real-time, banks have immediate visibility into the status of their transactions, addressing the growing need for faster settlement processes. They can proactively identify and address any issues that may arise, enabling them to revolutionise their cross-border payment settlement processes with increased efficiency and speed.
Significance of real-time visibility and insight
Real-time visibility and insight are indispensable in FX activity, especially given the dynamic nature of currency markets and the need for quick decision-making to capitalise on opportunities and mitigate risks. The Realiti suite is the only liquidity intelligence solution to deliver real-time, enterprise-wide 360° visibility of a firm’s liquidity landscape, control over treasury activities and value-creating insights. All in one place. Helmut Mannhardt, Barclay’s Global Head of Funding & Liquidity Management, underscores Realiti’s value in meeting regulatory requirements and optimising liquidity management across diverse currencies and legal entities.
Realiti’s staged rollout plan ensures that high-priority items, including regulatory compliance, are addressed first. This approach allows treasuries to experience immediate benefits while providing the flexibility to customise and expand functionality in subsequent stages.
The balancing act
It is imperative to strike a balance, or at least consider, between reducing settlement and concentration risk but potentially amplify the likes of liquidity and operational risk. This does indeed extend beyond FX, whereby the crucial factor is to assess whether such amplification is warranted and, if so, to implement measures to mitigate it. Having a single view of all locations is a significant step forward in this regard. For instance, and in its simplest form, logging onto a portal for one or a handful of accounts may be manageable, managing over 1500 accounts globally would be impractical.
Maintaining a cautious approach ensures that advancements in settlement technology do not introduce systemic vulnerabilities or undermine the stability of the financial infrastructure. As the industry embraces innovation, prudent risk management practices remain paramount to safeguarding the integrity and resilience of cross-border payment systems.
Real-time settlement, visibility, and insights form the foundation for this approach, providing a safety net that encourages innovation and strategic decision-making. That’s an intelligent approach to high finance.
