Using technology to overcome the operational challenges of FX settlement netting

It is widely acknowledged by both industry regulators and market participants that the netting of
FX transactions reduces settlement risk and allows intraday funding to be managed more precisely.
Yet the percentage of netted transactions is still surprisingly low. What are the operational
challenges to the netting process and how can these be overcome?

Highlighted as a concern by the Bank
for International Settlements (BIS) in its
2019 Triennial Survey¹, the issue of FX
settlement risk has continued to gain
industry momentum. Most recently,
in May 2022, the Global Foreign
Exchange Division (GFXD) published
a paper with recommendations for
reducing settlement risk², including the
increase in netting of transactions over
gross settlement. Simply put, netting
reduces both the number of payments
that a bank needs to make and the
cumulative value of those payments,
decreasing the impact of a potential
settlement default or failure.
Netting has other benefits too:
reducing the number of payments
being made by the parties to any given
transaction in turn reduces the number
of manual processes involved and
the possibility of error. The cash flows
and funding requirements for each of
the counterparties are also reduced
because they are settling netted
volumes rather than each underlying
transaction. Nostro accounts can
therefore be managed more effectively
and the cost of funding managed
more precisely.

TO NET OR NOT TO NET?

Why, then, does netting not take place
as a matter of course? The answer
lies in the pressure that operations
and payments teams find themselves
udner, relying on manual processes
and legacy technology and lacking the
flexibility to net on a continuous or
configurable basis.

In many ways it is simply easier for firms
not to net: so long as post-trade systems
are effectively integrated, settling gross
allows for straight-through processing
all the way from the trade matching
process through to settlement, whereas
netting requires operational input in two
or three different ways.

Firstly, the netting calculation process
needs to be run in a consistent
manner; counterparties need to agree
which products and currencies to
include. Secondly, they need to agree
on when the calculation stops being
run – for example on value date, or
the day prior to value date. It’s vital
to have a consistent process, yet
processes and preferences can vary
between counterparties.

The upshot is that both parties to the
netted transactions need to agree the

outcome of the netting calculation,
i.e. the population of transactions and,
therefore, the netted obligations of
each party. It is this agreement process
in particular that is operationally
intensive, requiring a variety of end
user computer processes, as well
as offline communication. Often,
relationships are managed manually
and individually.

This operational intensiveness is
demanding and time-consuming and
can lead to errors. It often also means
that the final agreement on what is
to be settled is delayed, which can mean
that the actual payment is effected
hastily - again, creating an opportunity
for error.

TECHNOLOGY IS THE ANSWER

In order to focus on the twin issues of
settlement risk and efficient funding,
firms need to address the operational
burden that netting presents. For
consistency, it’s important for firms
to be able to net on a configurable
basis – i.e. by product,counterparty
and tenor - in a way that meets the
requirements of both parties.

The netting population needs to be
agreed as effectively as possible. The
cleanest way of doing this is to run a
common netting calculation based on
a single source of data where both
parties can have confidence that the
values used are correct and therefore
there is no need to reconcile the
outcomes separately. Payments can,
and should, be made very effectively
immediately thereafter.Baton Systems’
^TM solution is based around
Core-FX
the simultaneous exchange of equal
amounts in different currencies to
achieve PvP settlement. Core-FX runs
on DLT, providing a single source of
truth with a single netting calculation.

An alternative is for a firm to know
that it is netting in a way that is
as consistent as possible with the

preferences of its counterparty. If
there is a process in place to allow
for the automated exchange of
information on the netted values and
the population of the netting groups,
then there should be a very high
success rate of matching values and
population. Further, if that process
of exchanging information and
confirming a match is automated,
then operations teams will only need
to deal with exceptions, leaving them
free to concentrate manual resources
on those areas where there is a
genuine problem.

ELIMINATING SETTLEMENT RISK

In both cases the netting calculations
supported by Baton are highly
configurable at the counterparty and
currency level, including cut-off times
and products.

^TM solution
Baton’s Core-Payments
provides for netting on a currency level
with the payouts being sequenced
and released in an intelligent way
according to the settlement risk
apetite of a customer against its
counterparties. The configured netting
process is designed to be consistent
with the way the counterparty
operates. Baton has streamlined the
agreement process by automating
the transmission of the calculated
values as well as
the receipt and
interrogation of the response.

Settlement risk can be reduced by
netting, but what remains of that risk
can only be eliminated by settling
in a safe and controlled manner,
preferably on a PvP basis. This requires
a full, straight-through process which
takes a transaction from the point of
matching, through netting and all the
way to the point of safe settlement,
with full transparency throughout.
Baton offers a configurable and
flexible solution by netting on a
bilateral, rather than a multilateral,
basis and on a currency pair basis.

Currency pair netting is the only
way to effectively allow bilateral PvP
settlement to occur on-demand.

Furthermore, while multilateral netting
has proved to be very effective in
terms of netting down the values to be
settled, it forces a pool of participants
to a common process around timing,
meaning that both calculations and
settlement processes are fixed. Bilateral
netting and settlement processes give
control back to the participants.

SUPPLYING TECHNOLOGY TO MEET INDUSTRY DEMAND

From the BIS 2019 Triennial Report,
through the 2021 amendments to the
FX Global Code and, most recently,
the GFXD paper, the importance of
netting and PvP or safe settlement is
constantly being stressed. With the rise
of FX volumes and the reluctance by
some firms to use limited settlement
lines for FX purposes, the industry is
more invested than ever in achieving
safe settlement.

In the past, multilateral netting by
currency has proved an effective
way of reducing settlement risk and
has become the industry norm.
However, firms are now beginning
to understand that, by deploying
technology to net bilaterally by
currency pair, they can go further and
eliminate settlement risk with solutions
that integrate with PvP.

TM
Technology such as Baton-CORE
allows counterparties to access a single
source of truth with shared workflows
around netting and the ability to
agree and settle those netted values
without resorting to resource-heavy,
manual processes which are subject to
human error. FX market participants
are now beginning to recognise the
opportunities for safe settlement
which technology has to offer both
individual firms and the market as a
whole.