About Half of Global FX Market Exposed to Settlement Risk

Without immediate action, FX settlement risk will continue to accumulate and introduce vulnerabilities into the global financial system, says Margaret Law at CLS.

The foreign exchange (FX) market is global, vast, and operates 24 hours per day. Its effective functioning facilitates international commerce and is a pillar of a sound financial system. A disruption to the FX market – particularly a materialisation of FX settlement risk – could cause panic in markets around the world.

In recognition of this risk, the Basel Committee on Banking Supervision (BCBS) in February 2013 published supervisory guidance for managing risks associated with FX settlement, referred to as BCBS 241.

Following its publication, the BCBS expected banks and national supervisors to implement BCBS 241 in their jurisdictions, but seven years later, more work is required. The BCBS recognised this shortcoming in October 2019 and publicly acknowledged the need for further measures to mitigate FX settlement risk.

The Bank for International Settlements (BIS), in its Quarterly Review published in December 2019, concluded that a significant portion of the global FX market continues to be settled without payment-versus-payment (PvP) protection. Of the USD 18.7 trillion of daily gross FX payment obligations, USD 8.9 trillion (approximately half) is at risk.

In a time of an evolving macroeconomic and regulatory landscape, pressure to reduce cost and fees, and enhanced investor risk brought on by the Covid-19 pandemic, it is important for banks and buy-side firms to ensure FX settlement protection is in place.


Nearly 30 years ago, twenty major financial institutions formed a group which, with support from the central banking community, advanced the linked settlement concept – an arrangement involving simultaneous PvP exchange on each of the two legs of an FX transaction – that would eventually lead to the creation of CLS.

CLS’s FX settlement service (CLSSettlement) went live in September 2002 and today, its owners comprise over 70 of the world’s largest financial institutions. More than 25,000 third parties, primarily buy-side institutions, access CLSSettlement via CLS’s settlement members. It settles 18 actively traded currencies, including six from Asia, offering operational efficiencies and minimised costs, while delivering liquidity benefits and mitigating settlement risk.

Yet, a significant portion of global FX trades remains without PvP settlement protection. While the decline in the proportion of FX transactions settled with PvP protection is partly explained by some trades in CLS-eligible currencies being settled without risk mitigation, a significant percentage can be attributed to the growth in currencies not currently eligible for settlement in CLS.

CLS conducted its own analysis, leveraging the BIS Triennial Surveys, and found that for CLS-eligible currencies, daily gross FX payment volume equates to USD 5.34 trillion. CLS settles approximately 31 percent of those FX transactions, while the remaining 69 percent falls into two broad categories.

Approximately 31 percent can be attributed to “related party trades” and “give-up trades of prime brokers” – trade types not usually sent to CLS. And 38 percent are transactions that might be eligible for CLSSettlement, which may include internalised trades, low-value corporate trades, some portion of retail, and same-day trades.

Trades in which a non-CLS currency is on at least one side of the trade equate to approximately USD1.25 trillion – an increase of 35 percent in the three years since the BIS 2016 Triennial Survey. While USD and EUR are on one side of many of these trades, without PvP, both sides carry FX settlement risk.

FX trading in Asia

The growth of FX trading in many Asian currencies means that settlement risk has become an increasing concern for market participants in the region.

In addition, institutional investors (including superannuation funds in Australia, pensions in Japan, Korea and Taiwan, and insurers in Japan and Taiwan) are increasing their currency exposures as they invest in more offshore assets.

Following the BCBS 241 recommendations on the use of PvP settlement and netting, CLS has been working closely with the Japanese Financial Services Agency (FSA) and Bank of Japan (BOJ) to enable the FX payments of Japanese domiciled funds to be settled in CLSSettlement.

As of September 2020, twelve asset managers have participated in CLSSettlement for over 60 Japan domiciled funds via five trust banks. Many other asset managers, encouraged by the FSA itself, have already started the process to participate in CLSSettlement. As a result, the majority of FX settlement risk in Japan is expected to be mitigated via CLSSettlement by 2021.

Meanwhile, Australia’s growing superannuation industry is the second-largest pension market in the Asia Pacific region after Japan. Predicted to grow from almost USD 2 trillion to USD 3.7 trillion within a decade, superannuation funds face increasing pressure from their members to expand investments globally, resulting in increased asset allocation to foreign investments.

Last year, National Australia Bank’s 9th biennial “Superannuation FX Hedging Survey” found that on average, superannuation funds had 41 percent of their assets offshore (as of June 2019). Further, 72 percent of respondents indicated they planned to expand their allocation to international assets over the following two years.

This is supported by the nearly 90 percent increase in FX-related payment volumes from superannuation funds over the past three years, highlighting the urgent need for super funds to apply best practices in FX-related risk management to drive and maintain growth and protect their members. About three quarters of Australia’s 20 largest superannuation funds already use CLSSettlement to settle their FX trades.

While there is still a gap on the buy-side and adoption of PvP settlement has been largely fragmented, several large Australian superannuation funds – including VicSuper, AustralianSuper and QSuper – have recently signed up to the Global Foreign Exchange Committee’s (GFXC) FX Global Code.

Principle 50 of the Code specifically states that market participants should measure and monitor their settlement risk and seek to mitigate that risk wherever possible. Notably, in December 2019, the GXFC announced a number of priorities in updating the Code, including to better promote the Code to buy-side market participants.

Moving forward

As trading within the region grows, there is potential for increased exposure to FX settlement risk, especially for those trades settled in non-CLS eligible currencies. It is important to look at CLS’s role in mitigating settlement risk in the region.

Given the practical and legal hurdles of onboarding a currency in CLSSettlement, CLS believes the best way to address settlement risk for non-CLS currencies that are unlikely to overcome these hurdles is for the industry to work together to develop a solution to provide an alternative form of PvP protection for these currencies.

While it is vital for policymakers and national regulators to provide guidance on this issue, banks and non-banks can take steps to reduce this risk. This may entail evaluating existing operations to determine which transactions are not settling via PvP, and why. Based on this type of analysis, market players would be able to consider ways to address any identified risks.

Additionally, relevant industry codes or regulatory guidance could be reviewed and amended to further promote PvP as a best practice for market participants. In this vein, more can also be done to promote the FX Global Code, another driver for greater transparency and adoption of best practices in FX operations among the buy-side.

In Asia Pacific, several jurisdictions such as Hong Kong and Singapore have directly endorsed and implemented the Code into local rulebooks and codes. Meanwhile, Japan has replaced its local code of conduct with the FX Global Code in its entirety, supplementing it with local guidance to address unique market practices.

Widespread adoption of the Code is driving a push for improved operational efficiency and risk mitigation. Given the intense volatility observed in the global financial markets earlier this year, the GFXC has encouraged market participants to be especially aware of the risks associated with the FX transactions they undertake.

Although banks receive more consistent messaging encouraging settlement risk mitigation, other market participants that are increasingly transacting in the FX markets have not had access to such strong messaging around the need to mitigate FX settlement risk.

CLS has been engaged in dialogue with regulators and market participants to educate them on this risk and explore ways to collaborate to raise awareness of this pressing issue. CLS urges the regulatory community and the industry at large to join forces to reverse the expansion of FX settlement risk before the risk materialises and inflicts damage on markets and the global economy more broadly.

Margaret Law is Head of Client Management for APAC at CLS and an advocate for FX settlement protection. Before joining CLS, she worked for the Northern Trust Corporation, BAML, HSBC and Citibank.


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