CLS, the bank that plays a pivotal behind-the-scenes role in the global foreign exchange (FX) market, has added to warnings of a build-up of post-trade risks.
Foreign exchange is the world’s largest financial market, with daily trading volumes—as much as $19trn on a gross basis—dwarfing those in equities and bonds.
Almost all FX trades are agreed on a bilateral basis, with settlement between counterparties typically occurring two days after a transaction is agreed.
If one party to the trade doesn’t pay up, the failed settlement can cause a cascading effect through global markets, putting the whole financial system at risk.
CLS, which is owned by the largest FX-dealing banks, settles transactions on a so-called ‘payment-versus-payment’ (PvP) basis, effectively eliminating settlement risk.
PvP means that a payment in one currency occurs only if the payment in the other currency takes place, with CLS standing in the middle as guarantor.
CLS settles trades in 18 currencies, almost exclusively in developed markets. It is one of eight systemically important financial market utilities, as designated by the US Financial Stability Oversight Council.
In December, the Bank for International Settlements (BIS), which monitors the safety of the global financial system, warned that FX settlement risks are on the rise.
According to the BIS, the percentage of FX trades with PvP protection has fallen from 50 percent in 2013 to 40 percent in 2019, representing a reversal of the positive trend seen during the previous two decades.
The BIS cited the growing volumes of emerging market currency trading as one reason for the falling proportion of uncleared FX trades.
In a new paper released this week, CLS said it had studied the growing FX settlement risk in both CLS-eligible currencies and currencies not eligible for settlement across its books.
CLS said it currently settles only around 31 percent of the $5.43trn in daily FX transactions in eligible currencies. The uncleared trades in otherwise eligible currencies, it said, fall into two categories.
First, it said, currency trades with related parties or ‘give-up’ trades by prime brokers are not usually sent for clearing.
Second, CLS said, many internalised FX trades, low value corporate trades, some retail FX trades, and same-day trades in eligible currencies are also not being cleared.
Trades in these two categories have grown by 39 percent and 17 percent, respectively, between 2013 and 2019, CLS said in its paper.
In the paper, CLS called for immediate action to address the growth of FX settlement risk.
Specifically, CLS said, regulators and industry participants should update industry codes or regulatory guidance to promote PvP as a best practice.
For the increasing proportion of FX market trades that are taking place in non-eligible currencies, largely those in emerging markets, CLS said it does not expect a near-term shift towards PvP settlement.
It cited the absence of a legal framework regarding settlement finality as the main obstacle towards onboarding new currencies.
For such non-eligible currencies, CLS said that a ‘lite’ model that provides a form of PvP protection could be preferable to the outright risk that is taken today by market participants in trading these currency pairs.
Marc Bayle de Jessé, CEO of CLS, said in a statement:
“Despite industry consensus that payment-versus-payment (PvP) protection is the most effective method to mitigate settlement risk, its use has declined relative to an increase in market volumes and CLS volumes.”
“Most emerging market currencies are traded primarily against the USD or the EUR and, therefore, we are exploring options to reduce settlement risk through PvP solutions, at least for these pairs of currencies.”
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