The potential for Distributed

Ledger Technology to reduce

FX Settlement Risk

By Jerome Kemp, President, Baton Systems

Jerome Kemp
!

In 2019, the Bank for International
Settlements (BIS) Triennial Survey
estimated almost $9 trillion-worth of FX
MARKET COMMENTARY
payments remain at risk of settlement
failure on an average trading day and
reported PvP protected settlements
had dropped to approx. 40% of the
market¹. In an effort to eliminate
principal risk, in December 2020,
the BIS issued supervisory guidance
recommending using PvP settlement
where practicable² - a message echoed
in the recently updated FX Global
Code, with its increased emphasis on
the need for market participants to
reduce settlement risk and use PvP
mechanisms where available³.

Whilst various governance bodies are
calling on the industry to step-up and
take action, the challenge remains

that many FX market participants lack
access to the infrastructure necessary
to facilitate safe settlement.
FX is a market without a widely used
central exchange or clearing facility.
CLS offers Payment-vs-Payment (PvP)
settlement to its members across
a select number of central bank
currencies - reducing the risk of a
counterparty failing to fulfil their
settlement obligations. However, as
trading in emerging market currencies
continues to rise, for example from
2016 to 2019, daily average volume for
CNY grew by 41% to $285bn and RUB
by 24% to $72bn⁴, the proportion of
trades eligible for PvP protection is in
decline.

In 2020, the Financial Stability Board
(FSB) launched an initiative focused
on enhancing and de-risking crossborder payments⁵. Looking to the
revolutionary change in network
technology, the FSB committees
advocated that new technologies
can and will enable faster, cheaper,
transparent, and scalable payments for
a broad range of users in the banking
system⁶.

However, following years of under
investment in post-trade infrastructure,
many banks are heavily reliant on
legacy technology built around
central-server based architecture with

disparate interconnected systems,
running batch-processes and different
data schemas.

If access to PvP is to evolve in a
realistic timeframe it is therefore
likely to be via the co-existence of
innovative technologies that effectively
interoperate, non-intrusively, with the
legacy systems and processes prevalent
across financial institutions. Ripping out
and replacing existing infrastructure
(at this stage) is not an option for most
large banks.

WHERE DO WE GO FROM HERE?

Firstly, it’s evident that increasing
market access to secure PvP settlement
protection is fundamental. A more
inclusive approach is needed - one
that allows a broader range of market
participants and currency pairs to be
eligible for PvP settlement. If this could
be achieved without the dependency
on using central bank money, adding
new currency pairs would not prove so
challenging - making PvP a more viable
option for settling emerging market
currencies. This would bring an end
to the idea of ‘riskless settlement’ as a
privilege available to the happy few.

Secondly, the processes of managing
intraday exposures and obligations
during 24hour settlement cycles
needing to be streamlined, to provide

With the ability to consume data from a distributed ledger, market participants would be able to trigger payments at will throughout the trading day.

Moreover, reducing settlement
timeframes would also present the
possibility of multiple settlement
cycles taking place intraday, providing
participants with the ability to re-use
their cash, effectively further reducing
liquidity requirements.

counterparties real-time visibility and
greater certainty as to when exactly
their trades will settle.

If PvP settlement timeframes could be
reduced, liquidity could be liberated.
This would allow Treasury teams to
increase the usage and flow of capital
across the organisation, with access
to money that would have otherwise
been inaccessible for an elongated
period whilst the settlement process
completed.

Thirdly, creating an innovative
settlement ecosystem that allows
for the co-existence of configurable
network capabilities, using new
technologies such as distributed-ledger
technology (DLT), interoperating
(non-intrusively) with legacy systems
such as ledgers, payment gateways
and messaging systems and protocols,
would prove transformative. It would
ultimately allow for constructive
disruption through the use of
blockchain inspired technology in an
environment ripe for automation and
change.

With the ability to consume data from
a distributed ledger, market participants
would be able to trigger payments at
will throughout the trading day. DLT
would allow settlement participants
to efficiently transfer asset ownership
using collaborative and synchronised

Such a structure would offer
capital market firms the option to
continue leveraging their existing
communication protocols and core
systems, whilst eliminating the impact
of inflexible batch-based, fragmented
infrastructures. The introduction of DLT
would afford settlement participants
complete and real-time visibility of all
settlement actions, offering a single
source of truth and the ability for
all interactions to instantly become
immutable facts. This would deliver
a level of transparency and certainty
unachievable with traditional bilateral
settlement - significantly reducing
settlement risk.

The ability for this data to be then
consumed by software that could
determine the payment frequency
and initiate settlements following the
trigger of pre-set thresholds and the
rails over which the funds will transmit,
would provide even greater control.

workflows, operating across real
accounts that hold real assets (negating
the need for tokenisation). This
simultaneous change of ownership
is at the core of PvP practices,
allowing settlement participants to
benefit from the latest advancements
in decentralised technology with
settlement finality enforced by
jurisdiction-specific rule sets.

There is a clear need for flexible, safe
and robust settlement mechanisms
for all currencies and all market
participants. The status quo needs to
evolve if we are to effectively curtail
settlement risk exposure.

1. https://www.bis.org/publ/qtrpdf/r_qt1912x.htm
2. https://www.bis.org/press/201217_letter.pdf
3. https://www.globalfxc.org/docs/fx_global.pdf
4. https://stats.bis.org/statx/srs/table/d11.3
5. See FSB Enhancing Cross-Border Payments Stage 1

The distributed ledger technology required to enable firms to better
control their FX settlements and manage intra-day funding requirements
with confidence, is available to market participants today, contact info@batonsystems.com for more information. If you’d like to learn more about
FX settlement risk, lessons from the cleared derivative markets (learned
the hard way in response to the Global Financial Crisis) and the challenges
of the market’s existing infrastructure download our white paper: Stress
Fatigue: Addressing the urgent threat of settlement risk in the global
financial system. https://pay21.batonsystems.com/stress-fatigue/

Report to the G20 at https://www.fsb.org/2020/04/
enhancing-cross-border-payments-stage-1-report-tothe-g20/; Stage 1 Report to the G20: Technical background
report at https://www.fsb.org/wp-content/uploads/
P090420-2.pdf; CPMI Enhancing cross-border payments:

building blocks of a global roadmap Stage 2 Report to the
G20 at https://www.bis.org/cpmi/publ/d193.pdf; and FSB
Enhancing cross- border payments Stage 3 Roadmap at https://www.fsb.org/wp-content/uploads/P131020-1.pdf 6. FSB Stage 1 Report to the G20, op.cit.