The foreign exchange market is the world’s largest capital market, with the Bank for International Settlements (BIS) reporting average daily trading volumes of US$6.6 trillion in 2019. In November 2019, the BIS Quarterly Review found that the proportion of foreign exchange (FX) trades with payment-versus-payment (PVP) protection appears to have fallen from 50% in 2013 to 40% in 2019, highlighting the urgent need for the FX market to expand settlement risk mitigation.
Adoption of a PVP settlement system ensures that both sides of an FX trade settle simultaneously, mitigating the risk that one trading party delivers the currency it sold but does not receive the currency it bought from its counterparty. Without PVP, counterparties must rely on non-PVP settlement arrangements such as bilateral gross settlement and bilateral net settlement, which still expose counterparties to varying degrees of FX settlement and credit risk.
One reason stated for the decrease in PVP adoption is the growth of trading in currencies not eligible for CLSSettlement, CLS’s PVP FX settlement service. The growth of FX trading in many Asian currencies in particular means that the issue of settlement risk has become an increasing concern in the region. It is essential that all market participants, including the buy side, implement appropriate FX risk mitigation services. In addition, institutional investors, including pensions in Australia, Japan, Korea and Taiwan and insurers in Japan and Taiwan, are increasing their currency exposures as they invest in more offshore assets, resulting in a greater need to reduce currency settlement risk.
As a result of the evolving regulatory environment, asset owners are increasingly focused on principles such as governance and controls, protection of stakeholder interests, and safeguarding of assets. If a buy-side firm can show adherence to these principles through excellence in operations and risk management, it satisfies the needs of its clients as well as its obligations to the relevant regulators. Several regulators, including the Hong Kong Monetary Authority, specifically require firms to mitigate settlement. Therefore, the adoption of a PVP settlement service to mitigate FX settlement risk is vital for all buyside firms.
Following guidance from the Basel Committee on Banking Supervision recommending the use of PVP settlement and netting, CLS has been working closely with the Japanese Financial Services Agency and Bank of Japan to enable Fund FX to settle via CLSSettlement. As of September 2020, thirteen asset managers have participated in CLSSettlement for over 60 Japan domiciled funds via five trust banks. As many asset managers have already started the process of participating in CLSSettlement, the majority of FX settlement risk in the currencies that CLS settles for Japanese participants is expected to be mitigated via CLSSettlement by 2021.
The FX Global Code also drives greater transparency and best practices in buyside FX operations. Not only does the code advocate best practices in FX operations, but Principle 50 specifically states that market participants should measure and monitor their settlement risk and seek to mitigate that risk wherever possible. In Asia-Pacific, several jurisdictions, such as 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 FX Global Code, supplemented with local guidance to address unique practices in the Tokyo market. Widespread adoption of the FX Global 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 Global Foreign Exchange Committee (GFXC) has encouraged market participants to be especially aware of the risks associated with the transactions they undertake.
There is still a gap on the buyside, in particular banking sector clients such as fund managers, pensions and hedge funds, where adoption has been fragmented. In December 2019, the GFXC announced a number of priorities in updating the Global FX Code, including the need to develop further materials for promoting it to buyside market participants. There are still asset managers and pensions signing up to the code. Notably, several large Australian superannuation funds recently signed up to it, including VicSuper and AustralianSuper at the end of 2019 and QSuper in 2020.
As trading within the Asia-Pacific 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 now to look at furthering CLS’s role to mitigate settlement risk in the region. Several currencies in the region are already settled in CLSSettlement – Japanese yen, Korean won and Australian, Hong Kong, New Zealand and Singapore dollars. The emerging market currencies would also need to meet CLS’s currency onboarding standards to become eligible for settlement. 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 is for the industry to work together to develop a solution to provide an alternative form of PVP protection to that provided in CLSSettlement.
CLS has urged the regulatory community and the industry at large to join forces to reverse the expansion of FX settlement risk before it leads to damage in the markets and the economy more broadly. It is vital for regulators to provide guidance, especially outside of banks, where market participants increasing their FX activity have not yet received strong messaging around the need to mitigate FX settlement risk. CLS has been engaged with regulators and market participants to educate them on this risk and to explore ways to collaborate and raise awareness of this increasingly pressing issue. It will take a co-operative effort between the industry and the regulatory community to take this work forward and to ensure its success.
Margaret Law is the head of client management for the Asia-Pacific region at CLS.