The benefits of automated, bilateral netting integrated with on-demand PvP settlement

Why actionable bilateral netting offers flexibility to counterparties and how automation of the entire process from trade matching through to settlement improves operational efficiency and reduces settlement risk.

In a previous blog post I outlined the importance of netting as part of the FX post-trade workflow. Netting reduces the number of payments that a bank needs to make, as well as reducing the cumulative value of those payments. Because the notionals being exchanged are reduced, netting decreases the impact of a settlement default or failure.

Despite the desirability of the process, however, it’s always surprising how few transactions are actually netted. There is significant pressure on operations and payments teams relying on a combination of manual processes and legacy technology, without the flexibility to net on a continuous or configurable basis. Furthermore, netting only goes part of the way towards resolving the issues around settlement risk. Even though a bank may successfully net down the values that it is paying and receiving with a specific counterparty, in order to eliminate settlement risk, settlement needs to take place on a PvP basis. Only when the entire process is covered do firms – and the market as a whole – get the full value of automation and of safe settlement.

As part of its May 2022 recommendations for reducing settlement risk, the GFXD Global FX Division highlighted the desirability of automation, which reduces both the operational burden and the likelihood of error resulting from manually-intensive processes.    

At Baton, our solutions always cover both automated netting processing – that is, the calculation and the agreement of the netted values – and the safe settlement of those netted values.

 Netting: Not as simple as it sounds

On the face of it, netting is a simple question of summing the transactions that have been entered into with like characteristics and arriving at netted values. However, the first challenge for a bank is deciding which products to include: the ISDA Master Agreement cites a broad range of products which can be included in netting calculations, but a firm will generally silo the netting process into specific products such as dealing with cash FX and then options separately.

The second challenge is around timing. There are valid reasons why counterparties enter into transactions that settle for value tomorrow or even settle value today, and last minute adjustment trades are quite common. One of the challenging things around many netting processes is agreeing the population of transactions that should be included in that netting process. Without automation, there will often be transactions that fall outside those netting groups and end up being settled individually.

Additionally, there are often valid reasons why one of the parties will want to either add a transaction to, or remove a transaction from, a netting group. It’s important that they are able to do so in a manner that does not then create operational burden and risk and, indeed, undue settlement risk.

Multilateral netting vs. bilateral netting

Netting can be bilateral or multilateral. Bilateral netting occurs when two parties net the transactions which they specifically have done with one another which have common characteristics: that is, the same currency or currency pair and the same value date.

Multilateral netting, by contrast, is based around a pool of participants where each party’s net obligation to the other parties combined, is calculated.

Although multilateral netting has the benefit of most effectively netting down the values that are to be settled, it is the less flexible option. Certain offerings, for example, oblige all counterparties to operate in sync with one another from a timing perspective, meaning that both the calculations and the settlement processes are fixed. This can present problems when transactions are made for valid reasons outside pre-determined cut-off times. Settling such transactions via these means may not be possible and other settlement processes may need to be employed.

By contrast, bilateral netting can be much more flexible because there are only two parties to a transaction. 

Baton’s technology enables calculations to be run continuously until both parties are ready to settle – this can take place multiple times a day, on demand.   

Currency vs. currency pair

Another consideration is whether netting is taking place on a single currency or a currency pair basis. Most netting in the FX market is done on a single currency basis; that is, by looking at the sum of all transactions, whether they are netted on a bilateral or multilateral basis, and arriving at a single payment or receipt for each currency traded.

Currency pair netting, on the other hand, is the process of netting transactions which have the same currency pair, counterparty pair and value date. 

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

How Baton enables bilateral netting

Baton’s solutions offer bilateral netting on a currency and currency pair basis. Our Core-FX™ solution, which delivers true PvP, is based around currency pair netting and the simultaneous exchange of equal amounts in different currencies to achieve PvP settlement.

Baton’s Core-Payments™ solution provides for netting on a currency level with the payouts being sequenced and released in an intelligent way according to the settlement risk appetite that our customer has against its counterparties.

In both cases the netting calculations supported by Baton are highly configurable at the counterparty and currency level, including cut-off times and products. This results in a streamlined agreement process.

In the case of Core-FX, which runs on a single source of truth with a single netting calculation, both parties are using that calculation so agreement is implicit.

In the case of Core-Payments, the configured netting process is designed to be consistent with the way the counterparty operates. Baton has streamlined the agreement process by capturing the calculation and automating the transmission of the calculation and the receipt and interrogation of the response.

Baton’s solutions take a transaction from the point of matching, through netting and  all the way to the point of safe settlement, with full transparency throughout.

With most banks looking to simplify processes and reduce reliance on manual procedures, we are able to offer huge value to our customers by pulling this together into a single platform.  

I hope you have found this blog useful in explaining the benefits of automated bilateral netting. If you have any questions or would like to learn more about Baton Core-FX or Baton Core-Payments please don’t hesitate to contact me at [email protected].