Mitigating FX Settlement Risk in Japan’s Pensions Industry

Margaret Law and Makoto Miyazaki discuss the need for Japanese pension funds to adopt PvP settlement to mitigate FX settlement risk.

In 2020, pension assets across the largest pensions’ markets increased 11%, according to the Global Pensions Assets Study 2021 by Willis Towers Watson. This same study also concluded that pensions are the dominant asset owner segment, constituting 57% of global assets with pension assets reaching USD 46.7 trillion worldwide at the end of 2019.[1]

In particular, Asia-Pacific pension funds have been beating their peers in terms of asset value growth. According to a report on the world’s top 300 pension funds by the Thinking Ahead Institute, assets under management (AUM) of the top 20 pension funds grew 8.1% year-on-year in 2019, led by a 10.6% growth in the assets of APAC funds.[2] However, many will continue to face a tough time ahead as the market impact of the Covid-19 pandemic will likely delay urgently needed reforms.

Despite this, the Government Pension Investment Fund of Japan (GPIF) remains the world’s largest pension fund, with JPY 177.7 trillion (USD 1.72 trillion) in AUM (as of December 2020), over 40 percent more than the second-largest fund, the Government Pension Fund of Norway.

As pension funds maintain their status as one of the largest asset owners globally, they have diversified their portfolios’ asset classes and are increasing foreign investments to gain access to flourishing foreign markets with higher yields that can better support the growing and ageing population relying on them. This trend toward foreign investments has led to increased foreign exchange (FX) trading and hedging within portfolios.

Asset globalisation and settlement risk

As of 2018, foreign investments accounted for roughly a third of global pension funds’ total assets under management and 34% of total pension investments (compared to 31% in 2014).[3] Increasingly, this diversification is seen as necessary for the success of pension funds since safe-haven investments are less attractive in a consistently low interest rate environment.

Foreign exchange settlement risk exposure will likely increase as the pension industry grows and continues to move toward offshore assets, including into emerging markets. Typically, pension funds work with their custodians or, in the Japan market, their trust banks (and/or their externally appointed managers) to discuss the options available to mitigate FX settlement risk, optimise liquidity and improve operational efficiency.

Pension funds’ increased focus on FX settlement risk mitigation echoes the sell side’s response to the Basel Committee on Banking Supervision (BCBS) guidance for managing settlement risk in FX transactions, first published in 2000. Since that time, the FX market has made substantial progress in reducing the risks associated with settling FX transactions, and banks have made strides toward improving governance arrangements and other settlement-related risks.

However, the Bank for International Settlements’ (BIS) Quarterly Review (December 2019) suggests this risk is on the rise.[4] The Committee on Payments and Market Infrastructures (CPMI) issued a report in 2020 recommending the use of payment-versus-payment (PvP) arrangements, where practicable, to reduce settlement risk when settling FX transactions.[5] A PvP settlement system ensures that both sides of an FX trade settle simultaneously, mitigating the risk that one counterparty delivers the currency it sold but does not receive the currency it bought from its counterparty.

CLS was created in 2002 at the behest of the G20 central banks during a time of unprecedented collaboration among FX market participants. The introduction of CLSSettlement, a unique PvP multicurrency settlement system, substantially reduced settlement risk across the FX market.

However, despite the growing adoption of PvP over the years, the BIS Quarterly Review suggests that FX settlement risk has increased since 2013 in both relative and absolute terms. It found that the proportion of FX trades with PvP protection appears to have fallen from 50% in 2013 to 40% in 2019, due in part to the growth of trading in currencies not eligible for CLSSettlement, such as those of emerging market economies.

When viewed alongside the pension industry’s substantial growth of market share, the BIS data reinforces the need for all market participants to be aware of their exposure to FX settlement risk and to leverage the robust services available to mitigate it.

FX Global Code and pension funds

The global pension industry’s growth and expanding interest in alternative investments have drawn the attention of regulators, which will drive new and increased regulation, governance and transparency.

Gradually, several pension funds have begun to adopt industry best practices within the market by signing up to the FX Global Code (the Code), which is promoted and maintained by the Global Foreign Exchange Committee (GFXC). The Code is a set of 55 principles established through collaboration between central banks and market participants from 16 jurisdictions to promote the highest ethical standards and best practices for the FX market.

Principle 50 of the Code specifically states that market participants should measure and monitor their settlement risk and seek to use settlement services that mitigate that risk – including by using PvP settlement mechanisms – whenever practicable. In Asia Pacific, several jurisdictions including Hong Kong and Singapore have directly endorsed and implemented the Code into local rule books and codes, and the Tokyo Foreign Exchange Market Committee has replaced its local code of conduct with the Code, supplemented with local guidance to address unique practices in the Tokyo market.

Adoption by the buy side has been fragmented, and more can still be done to encourage pension funds to sign a Statement of Commitment to the Code. Globally, only 11 pension funds have signed up to the Code, and none are in Japan.[6] In September 2020, GFXC announced that it will strengthen its guidance on the management of settlement risk as part of its current review of the FX Global Code.

Japan is a prominent example of how both the regulatory bodies and the industry are proactively coming together to identify and tackle settlement risk. While there were no Japanese funds mitigating FX settlement risk prior to 2018, today around 40 asset managers have started settling FX through CLSSettlement to mitigate risk through their trust banks.

The Power of PvP

As pension funds in Japan increase their investments overseas, they hold more foreign currency in their portfolios that could be hedged through FX trading.

This is supported by data from CLS, which settles more FX payments than any other settlement service. Analysis of CLS data suggests the volume of pension fund FX payments settled in CLSSettlement increased approximately 40% globally and over 75% in the Asia Pacific region over three years (2016-2019).

In addition to fund performance and cost reduction, pensions are increasingly focused on principles such as governance and controls, protection of member interests and safeguarding of assets, partly because of the evolving regulatory environment. When a pension can provide evidence of its adherence to these principles — through excellence in operations and risk management, such as the adoption of a PvP settlement service to mitigate FX settlement risk — it satisfies the requirements of its members as well as relevant regulatory obligations.

Click here to read more on ‘Pensions: take charge of currency risk’, a whitepaper by CLS.

[1] Willis Towers Watson: “Thinking Ahead Institute Research – Global Pension Assets Study” (February 2021)
[2] Willis Towers Watson: “Thinking Ahead Institute Research – The world’s largest pension funds – 2020” (September 2020)
[3] “Beyond their Borders: Evolution of Foreign Investments by Pension Funds,” updated and re-published by PwC in 2020
[4] BIS: “BIS Quarterly Review – International banking and financial market developments” (December 2019), specifically Bech and Holden: “FX Settlement Risk Remains Significant” (December 2019)
[5] CPMI: Enhancing cross-border payments: building blocks of a global roadmap, Stage 2 report to the G20, 13 July 2020:
[6] Global Foreign Exchange Committee, Global Index of Public Registers

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