Insights & Analysis

The optimal model for mitigating FX settlement risk

1st September, 2023|Keith Tippell, chief product officer at CLS

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By Keith Tippell, chief product officer at CLS

By Keith Tippell, chief product officer at CLS

In recent years, policymakers and regulators have renewed their focus on mitigating FX settlement risk. They have been looking at how payment-versus-payment settlement can be effected for currencies where it is not currently available, predominantly in emerging markets. The increased interest in mitigating FX settlement risk has brought to the fore debate regarding the optimal model to tackle this type of risk. Here, CLS provides five reasons why financial market infrastructures (FMIs) are best placed to address it.

Proven operational resilience

First, FMIs are highly regulated entities that are subject to rules and standards designed to protect the financial industry. These standards ensure that the infrastructure supporting global financial markets is robust and able to withstand market stress – resilience that was put to the test during the Covid-19 pandemic. The pandemic brought extreme market volatility from late February through March 2020, and despite a sharp increase in CLS volumes (approximately 20% higher than average in March 2020), CLS continued to reliably deliver its full range of services to the FX market every day.

Best-in-class risk management

Second, FMIs have best-in-class risk management practices. This is critical for operational resilience. CLS’s risk management framework is based on a robust and integrated approach that considers all relevant risk including credit, market, liquidity, operational, legal and compliance risks. As a global FMI, CLS must adopt sophisticated yet flexible risk management practices that can adapt to risks originating from financial market fluctuations. CLS continues to enhance its risk management frameworks, policies and procedures to ensure their effectiveness. This involves identifying, assessing and managing risks while also strengthening the risk culture within the organisation.

Public-private partnership

Third, many FMIs are public-private partnerships. FMIs like CLS sit at the centre of their industry, positioning them perfectly to work with both the public and private sectors in responding to industry needs. This approach helps to ensure that a solution will reflect requirements across the market and achieve sufficient industry investment and standardisation. For example, CLS’s settlement service, CLSSettlement, not only mitigates settlement risk but also delivers commercial benefits such as funding and operational efficiency. In particular, CLSSettlement reduces the net funding required of each of its members by as much as 99% through multilateral netting and its in-out swaps program. This safe and efficient liquidity optimisation has been one of the foundations for the fivefold expansion of the global FX market since CLS’s launch in 2002.

Measured innovation

Fourth, FMIs’ focus on safety helps to ensure that the technological solutions they deliver will prioritise safety and resilience. FMIs are subject to strict rules and regulatory oversight, but this does not prevent them from constantly evaluating new opportunities to deliver enhanced services. However, any new technology solution for financial markets must deliver efficiencies and/or reduce costs while also meeting extraordinarily high standards of resilience. Further, technology can only transform the market when it is translated into solutions that solve real business problems. FMIs like CLS have the required deep understanding of business processes and platforms coupled with appropriate oversight, governance, credibility and trust to deliver save and resilient solutions.

The launch of CLSNet, an automated bilateral netting calculation service, is testament to CLS’s ongoing ability to address the growing settlement risk in emerging markets currencies through safe innovation. CLSNet has experienced record growth this year. In the first half of 2023, the service saw a 400% year-on-year increase in average daily volume of net calculations, and in June 2023 it reached a record daily notional of $306 billion (£241bn) in net calculations, highlighting its network effect.

Operation at scale

Finally, FMIs enable operations at scale and the building of global ecosystems with broad participation, thereby increasing benefits for participants. The success of the FMI model for FX settlement risk mitigation is evident in the growth of PvP settlement volumes and the CLSSettlement community. Since 2021, there has been a 10% increase in CLSSettlement volumes, to an average of $6.5 trillion settled per day in 2023.

In addition, a CLS settlement risk analysis conducted in collaboration with a number of global bank members showed that of the FX transactions eligible for CLSSettlement (which comprise 80% of all FX transactions), on average 51% of the traded notional is settled through CLSSettlement, while most of the remainder comprises inter-branch and inter-affiliate trades or trades where settlement occurs via a single currency cashflow or over accounts within the banks’ direct control.

CLS welcomes new methods to reduce settlement risk across the FX market. However, for any new solution that has systemic risk management implications, the relevant legal, regulatory and policy implications need to be considered alongside the technology that delivers the solution. FMIs are regulated entities held to stringent rules and standards to protect the financial industry. It is essential that all service providers that mitigate financial market risk should satisfy similar criteria to FMIs to ensure that innovation in financial markets does not introduce new risks.