How FX Netting Can Improve Funding and Liquidity

Historically, FX transactions have predominantly been settled on a gross basis – that’s to say, every underlying FX transaction with the same currency pair and value date has been settled individually and independently of all other transactions.

The ISDA Master Agreement, under which most wholesale market participants operate, includes the capability to net transactions. Netted transactions allow the two transacting parties to net their obligations and then to settle only the net values, rather than each underlying transaction.  

Recognised as a way to reduce FX settlement risk and improve the efficiency and effectiveness of the settlement process, encouraging increased fx netting is one of the cornerstones of the updated FX Global Code. FX netting reduces the sum of the overall notionals being exchanged between two counterparties, which, by definition, reduces FX settlement risk. It also reduces the number of payments being made, thereby reducing the amount of funding or liquidity required.

“Recognised as a way to reduce FX settlement risk and improve the efficiency and effectiveness of the settlement process, encouraging increased fx netting is one of the cornerstones of the updated FX Global Code”

There is a flip side, however. FX netting requires the two transacting parties to add an extra stage into their settlement process. Having agreed to net, they then need to agree on the FX  netted values so that settlement can take place. While most firms would aspire to net as many transactions as they can, a manual agreement process gives rise to an increased operational burden. This means that, although fx netting is becoming more common, less flow is netted than might be expected.

However, FX netting, when fully automated, ceases to be an operational concern. There are solutions available now, including Baton’s FX netting workflows and capabilities, which fully automate the process, eradicating the incremental operational burden.

“However, fx netting, when fully automated, ceases to be an operational concern”

To Net FX or Not? Gross settlement Considerations

The Committee on Payments and Market Infrastructures (CPMI) published a report in late July 2022 entitled Facilitating increased adoption of payment versus payment (PvP) in which it outlines the different PvP options that currently exist (of the eleven solutions submitted in response to a call for ideas, only Baton’s FX PvP settlement solution is currently live). The report breaks down the netting process for settlements into three broad categories: those that work off multilateral netting, those that work off bilateral netting, and those that settle on a gross basis.

Whichever process is adopted, firms which settle on a PvP basis eliminate their FX settlement risk. However, the absence of fx netting for those solutions that settle gross will likely be a disadvantage to users as and when those systems go live. From a funding and liquidity perspective, the FX settlement process in these cases will be suboptimal. Instead of settling one value, i.e. the net of a large number of transactions, the participants will be required to settle each underlying transaction. Their balances will, therefore oscillate much more and potentially with far greater amplitude.

In short, settling gross is disadvantageous to funding and liquidity. Not only is the number and overall notional value of transactions to be settled higher, but so are the payment costs and funding requirements. Liquidity management is an expensive business: a 2018 report by Oliver Wyman estimated that, for large banks, the annual cost of managing intraday liquidity can be somewhere between $100m and $300m.

“Settling gross is disadvantageous to funding and liquidity”

Netting benefits the internal teams responsible for funding the accounts held by a bank to meet its payment obligations. In addition to knowing as far as possible which transactions are to be settled, they are also able to reduce the number and amplitude of transactions.

Baton’s approach to FX netting

Baton Core-FX™ allows the fully automated, configurable netting of FX transactions, with settlement on a PvP basis. Automation removes the incremental operational workload, while the collaborative nature of the process and the fact that a single source of data is used, reassures both parties that the results they are seeing from a fx netting calculation perspective are consistent with their counterparty’s. The fx netting process that Baton operates is continuous, running against every transaction that is booked until the scheduled time for the close-off of the relevant fx netting set on value date.

“Baton Core-FX™ allows the fully automated, configurable netting of transactions, with settlement on a PvP basis”

The typical usage we see at Baton is where a pair of counterparties will elect to settle each currency pair at defined times on value date. The settlement process itself takes approximately five minutes. The exchange of ownership is simultaneous and instantaneous. The solution also provides the flexibility for participants to elect to settle one or more transactions on a gross basis, should they choose to do so.

“The solution also provides the flexibility for participants to elect to settle one or more transactions on a gross basis, should they choose to do so”

What makes Baton’s FX netting solution different?

Baton Core-FX offers configurable bilateral FX netting. Configurations for each settlement participant can be set by counterparty, currency pair, and product. A firm using Core-FX can schedule and predict settlement events on, or for, each value date and, therefore better manage and optimise its use of funding.

“A firm using Core-FX can schedule and predict settlement events on, or for, each value date, and therefore can manage and optimise its use of funding”

Bilateral FX netting allows for that configuration between the settlement parties. Multilateral netting in comparison, although recognised to be very efficient, requires that the settlement process is operated on an industry-wide batch basis. This may not suit individual firms from the perspectives of both operational workload and access to funding, meaning that other processes need to be employed. With only two parties to a transaction, bilateral netting offers much greater flexibility.

I hope you have found this blog useful in explaining the impact of gross and net settlements on funding and liquidity. If you have any questions or would like to learn more about Baton Core-FX please don’t hesitate to contact me at [email protected].