Cross-border payments sit at the heart of international trade and economic activity and, by their very nature, involve the settlement of an FX transaction which requires payment of one currency for receipt of another. One of the main risks in such transactions – settlement risk – is that one party delivers the currency it sold but does not receive the currency it bought from its counterparty, resulting in a loss of principal. </p> Such a loss may be manageable if the amount is small. However, today’s global FX market is anything but small – it is the largest financial market in the world with an average daily volume of USD6.6 trillion¹. And in recent years, regulators and industry participants alike have become increasingly concerned that FX settlement risk may be reaching levels that threaten global financial stability.</p> The rise in settlement risk can be attributed to an increase in global trading of currencies that do not have access to payment-versus-payment (PvP) settlement mechanisms, such as CLSSettlement. This has heightened the focus on overall risk management in cross-border payments, with both the public sector and market participants expressing particular concern about rising settlement risk and calling for greater adoption of PvP mechanisms as the optimum solution to mitigate FX settlement risk.</p> To better understand settlement risk for currencies that are not currently eligible for CLSSettlement and how FX trades are settled in those currencies, CLS is working with its global settlement members to analyse their settlement activity. It is expected the results will provide further transparency on settlement behavior in the FX market to support a range of key policy initiatives.</p> To address the issue of PvP adoption more widely and deliver improvements to cross-border payments, collaboration between the public and private sectors is essential. Through two public policy initiatives, in consultation with the private sector, the industry is making great strides in addressing the issue of settlement risk in cross-border payments.</p> The first initiative is the Committee on Payments and Market Infrastructure’s (CPMI) request for industry input on improvements to existing payment infrastructures, and arrangements to enhance cross-border payments. This led to a recent policy initiative to encourage PvP adoption in the FX market through the inclusion of building block 9 of the Financial Stability Board’s roadmap to enhance cross-border payments².</p> The second is the three-year review of the FX Global Code (the Code) undertaken by the Global Foreign Exchange Committee (GFXC)³. The updated version of the Code includes amendments to the key principles concerning settlement risk – principles 35 and 50 – placing greater emphasis on the use of PvP settlement mechanisms where available, and providing more detailed guidance on the management of settlement risk where PvP settlement is not used. The changes to the Code will encourage FX market participants to explore ways to further mitigate risk and reduce operational costs by adopting a best practice approach to FX settlement risk management and netting.</p> In response to the need to increase PvP settlement in currencies that are not currently eligible for CLSSettlement, CLS has established a working group to evaluate market demand and explore potential solutions. Initial feedback shows a strong interest in an alternative PvP solution, and as a result, an industry pilot is underway which will evaluate the liquidity and settlement risk of potential models. For any solution to be a success, it will need to consider certain factors such as account structure, legal framework, and local market practices and regulations. While this initiative has considerable industry support and momentum behind it – any financial market infrastructure (FMI) solution must prioritise safety, stability, and scalability. Hence, any alternative PvP solution will require ample time for appropriate implementation.</p> The introduction of best practices related to mitigating settlement risk and efficient post-trade practices in the FX market is a high priority for market participants, policymakers and regulators. Collaboration is key to tackling settlement risk, and it is encouraging to see policymakers engaging with market participants on an ongoing basis. A strong public-private partnership will ensure that the market’s needs are fully understood and that any preferred solution obtains sufficient industry investment and support. Together, we can build a successful cross-border, alternative PvP solution that will reduce FX settlement risk in global financial markets.</p> ¹ Bank for International Settlements. "Foreign Exchange Turnover in April 2019". https://www.bis.org/statistics/rpfx19.htm</a></p> ² FSB. “Enhancing Cross-border Payments, Stage 3 Roadmap - October 2020”. https://www.fsb.org/2020/10/enhancing-cross-border-payments-stage-3-roadmap/</a> </p> ³ The Global Foreign Exchange Committee endorsed the outcomes of the Code review on 28 June 2021. https://www.globalfxc.org/docs/gfxc_3year_review_outcomes.pdf</a> </p>