Trust funds in Japan have started focusing on mitigating FX settlement risk, to which they have long been exposed. This article explains the change in focus and the factors behind this.
Following 2013 guidance from the Basel Committee on Banking Supervision (BCBS) recommending the use of payment-versus-payment (PvP) settlement and netting where appropriate, Japan’s Financial Services Agency (FSA), along with the Bank of Japan (BoJ), convened Japanese wholesale FX market participants to promote PvP settlement and assist the industry in adopting CLSSettlement.
From an FX trading perspective, pension and investment trust funds are two of the most active fund categories in Japan. Both have increased cross-border investments over time, aiming to improve performance under the prevailing Japanese negative interest rate environment.
For instance, the Government Pension Investment Fund (GPIF), the world’s largest pension plan with JPY 169 trillion (USD 1.57 trillion) in assets under management as of December 2019, recently announced a new policy to increase foreign asset allocation from 40% to 50% (25% each for foreign bonds and equities) of its total portfolio.
However, despite the steady increase of fund FX settling in CLSSettlement over the last decade globally, Japanese fund FX only started settling in CLSSettlement in the summer of 2018. Japan’s slow adoption of PvP can be attributed to market-specific factors, such as its unique fund FX structure, where trust banks act as an additional layer between an asset manager and a global custodian, as well as unique market practices in Japan such as frequent cancellation of individual FX hedge positions in case of early redemption.
BCBS FX guidance and FSA’s roundtable
In February 2013, the BCBS published “Supervisory guidance for managing risks associated with the settlement of foreign exchange transactions”, which stipulated that:
“A bank should eliminate principal risk by using FMIs [financial market infrastructures] that provide PvP settlement, where practicable.”
In 2016, the FSA established an industry roundtable to address complex structural issues through discussions with various stakeholders, including trust banks, asset managers, global custodians, FX brokers, CLS and the BoJ.
Four roundtables were held between December 2016 and June 2018, interspersed with several practitioners’ meetings. During this time, the Tokyo Foreign Exchange Market Committee (TFEMC) and Trust Companies Association of Japan jointly established the Fund FX Project Team (PT), which discussed how market practices should be standardised and streamlined to facilitate the implementation of PvP settlement for trust banks and FX brokers.
In August 2018, the FSA released a report outlining the agreed implementation timeframe, participation models and new market practices. The PT, in parallel, continued to address lingering issues, including the abolishment of existing third-party payments and the introduction of new netting practices for non-CLSSettlement trades. The PT eventually decided to discontinue third party payments by March 2021 because of the potential risk from an AML perspective.
Due to a large variance in IT systems and process flows across global and Japanese asset managers and FX banks, the roundtable agreed to take a phased approach, starting with an “initial phase” (October 2018-March 2019), and followed by a “fully-fledged phase” (October 2019-September 2020).
In the initial phase, those asset managers and FX banks with existing, but limited, IT and operational capabilities implemented PvP via CLS for higher risk transactions such as high value trades. In the fully-fledged phase and thereafter in 2021, onboarding of the remaining asset managers to CLSSettlement will continue to the maximum extent possible, in line with the agreed FSA timeframe.
Awareness-raising and CLS onboarding
As a means to increase awareness of the need for FX settlement risk mitigation among Japan-domiciled funds, CLS hosted two Fund Fora (2014 and 2017) and organised a trust bank working group (2015), along with a number of bilateral engagements with each trust bank, each focused on improving IT and operational readiness for the migration to PvP-based FX settlement.
CLS participation models
In order to have access to CLSSettlement, the roundtable proposed two participation models – the Custodian Model and the Trust Bank Model. In the former, a global custodian, an existing CLS settlement member, provides a trust bank with access to CLSSettlement, which enables participation by the funds entrusted to the trust bank. In the latter, a CLS settlement member bank (either an affiliate bank within the same financial group of the trust bank or an external bank) provides a trust bank with the service as a third-party service provider (TPSP) and the trust bank extends CLSSettlement to the funds.
As each model has its own process flows and benefits, trust banks can use both models depending on the specific requirements of the underlying funds.
Progress and challenges
As of May 2020, nine asset managers have participated in CLSSettlement for approximately 50 Japan-domiciled funds via five trust banks through both the initial phase and the early part of the full-fledged phase. However, this still accounts for a limited portion of the overall Japanese fund FX market.
As many asset managers have already started the onboarding process, the majority of FX settlement risk for currencies eligible for CLSSettlement is expected to be mitigated via CLSSettlement by 2021. One of the challenges highlighted by smaller NAV funds is the high cost of additional ongoing remittance fees due to the market-specific structure of Japanese fund FX. However, the risk mitigation benefits of using CLSSettlement along with operational efficiencies and liquidity savings are likely to lead to an overall cost reduction.
Beyond full ramp-up
In 2018, the PT announced new market practices for Japanese fund FX, including the use of CLSSettlement as a recommended industry standard, where practicable, or a standing settlement instruction (SSI) based settlement for non-CLS transactions.
The Investment Trust Association of Japan (JITA) encourages smaller NAV funds who may not adopt CLSSettlement to conduct netting for FX hedge trades by rolling-over with the same broker as the original trade’s counterparty so that settlement risk can be mitigated. However, as this arrangement may not be optimal from a best execution perspective, CLSNet – a standardised and automated bilateral payment netting calculation service – is an additional netting solution which six of the top ten global banks already use.
CLS is currently in discussions with the Japanese fund FX community to address how to mitigate risk and streamline operations for trust banks and FX brokers by using CLSNet as an industry-wide solution. Once the new market practices come into effect in 2021, and with the subsequent migration to a PvP-based FX settlement system and more robust netting arrangements, the Japanese fund FX market will become more efficient, effective and resilient.
Makoto Miyazaki is General Manager Japan and Korea for CLS Group.
 Japan is the third largest pension market globally after US and UK. (source: Global Pensions Assets Study 2020 by Willis Towers Watson)
 In March 2020, GPIF announced that currency-hedged foreign bonds will be classified as part of its domestic debt portfolio. Target allocation for domestic bonds is 25% of the total portfolio, plus/minus 7% as permissible deviation from the policy portfolio. (Source: GPIF).
 Fund FX settled value on CLS between 2008 and 2019 has increased by five times in absolute value and from 3% to 11% in percentage share within the total settled value of CLS. (Source: CLS)