Reduce the strain on liquidity management by splitting settlements

Any firm that is settling large amounts, especially in hard-to-fund currencies, will be familiar with the difficulties of accessing the liquidity required to meet their payment obligations. Splitting settlements is a natural consideration, however operational constraints have previously limited the appeal. 

In this blog post, Alex Knight explains how the ability to automatically agree and process split settlements can massively reduce the pressures around liquidity and eliminate “settlement log jams” whilst ensuring that the post-trade processes operate on a fully STP basis. When settlement splitting is achieved alongside both netting and PvP settlement THEN ITS REALLY GREAT. 

Splitting refers to the process by which parties to a settlement deliver their obligations in multiple transfers of smaller amounts on value date, the sum of which adds up to their full obligation. This allows the paying party/parties to lengthen the time period over which they need to secure the available funding required in order to meet their overall obligation, enabling easier and more efficient liquidity management.

Even with the benefits of netting, the notionals that need to be settled between a pair of counterparties can be very large. What’s important is not necessarily the absolute notional, but rather the amount of currency that needs to be delivered in the context of the available funding or liquidity for the currency or currencies that need to be settled, at the time that the settlement is due to take place.  An example often quoted is Turkish lira (TRY), but this challenge applies broadly across the markets, not only for individual firms that are seeking to optimise their cash usage, but also for the entire ecosystem of participants in cases where the ratio of expected settlements compared to available liquidity is high. 

Why firms are reluctant to split settlements

One of the challenges of split settlements is that extensive coordination is required within and between operations teams. Firms choosing to split are, by definition, increasing the number of settlements made, since each original settlement is broken down into smaller components. The reconciliation challenges are harder, and the overall process is generally perceived to be more convoluted and more complex, although this need not be the case. These factors, together with the many risk elements associated with settlements, make firms reluctant to embark on the process.

“The overall process of splitting settlements is generally perceived to be more convoluted and more complex, although this need not be the case”

Turkish lira: a case in point

Currencies such as the Turkish lira (TRY) are heavily traded yet have relatively low liquidity from a funding perspective. Collectively, market participants required to settle (often partially or wholly offsetting) obligations across a range of bilateral relationships can find themselves in a settlement log jam. Every participant, in effect, is waiting for another participant to meet its obligation. Because of this, the market convention is now that TRY is settled in small size.

The post-trade tail wagging the front-office dog

The fact that market convention now acknowledges that TRY settlements need to be made in small size has meant that the actual execution process has had to be amended. Many firms wanting to buy a large amount of TRY have chosen to adopt the practice of transacting in smaller size for no other reason than that existing operational processes don’t support split settlements easily. Inflexible post trade operational processes are, in effect, therefore dictating what the front office must do, a clear example of an unsatisfactory work-around.

“Inflexible post-trade operational processes are, in effect, dictating what the front office must do, a clear example of an unsatisfactory work-around”

Split Settlements: What does the market need?

Market participants need a process that allows for collaborative workflows which automatically and safely split settlements into agreed shapes that are defined by mutually agreed rules. These smaller shapes should also be settled on a riskless, or Payment versus Payment (PvP), basis as part of that process. This can be done on a purely bilateral basis, where a pair of counterparties agree what their settlement process is going to look like in terms of how and when they’re going to split. Alternatively, it can be agreed by multiple settlement participants, who collectively agree on a common framework and logic for splitting settlements between them.

“Market participants need a process that allows for collaborative workflows which automatically and safely split settlements into agreed shapes that are defined by mutually agreed rules”

This way, the overall market impact of all the settlements, from a funding perspective, is reduced. Therefore both market and counterparty pressure is relieved, creating a process that is both safe and operationally efficient.

“Both market and counterparty pressure is relieved, creating a process that is both safe and operationally efficient”

How Baton can help

Baton’s Core-FX™ solution applies collaborative workflows across the entire post-trade process, including netting and settlements. Participants can pre-agree the framework for splitting settlements either at a counterparty level or across multiple counterparties. When this is deployed, the settlements can occur in an entirely automated manner that can be repeated multiple times a day. This can be done with the benefit of PvP and with real-time transparency across the entire process whilst scarce liquidity is continuously transferred and recycled, avoiding settlement blockages.

As a business, we have recognised that split settlements offer firms significant benefits, not only in terms of reducing the cost of funding, but also in terms of enabling banks to do more business and reducing payments/liquidity risk.

As a result, whether settlements occur bilaterally or in a multilateral context, the ability to split those settlements into smaller sizes, if achieved with automation and transparency, can massively reduce the overall funding burden that the market has to bear and de-risk the settlement process for the industry as a whole.

“The ability to split settlements, if achieved with automation and transparency, can massively reduce the overall funding burden and de-risk the settlement process for the industry as a whole”

I hope you have found this blog useful in explaining how Baton’s collaborative and automated workflows, combined with netting capabilities and PvP settlement, can support firms with the settlement splitting process. To learn more about Core-FX, visit: https://batonsystems.com/pvp-settlement/