# 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’  
<sup>TM</sup> 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.

<sup>TM</sup> 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.