Article by Colin Lambert, originally posted on Profit & Loss.

With settlement risk very much on authorities’ agenda, Colin Lambert talks to Alex Knight, head of global sales and EMEA at Baton Systems, about the challenges facing the industry…and the solutions.

Colin Lambert: Last year the BIS surprised quite a few people by highlighting the scale of settlement risk in FX markets in its Triennial Survey, can you summarise the challenges the industry is facing in reducing settlement risk?

Alex Knight: This has become a much bigger issue since the BIS highlighted the gap in settlement risk and we think it boils down to one issue; getting the right assets to the right place at the right time – we refer to it as the synchronisation or orchestration of movement of assets and it’s an ongoing challenge for most banks.

Settlement risk is one aspect of the challenge and that’s the one everyone is talking about now, but there is also the need to more efficiently identify and manage funding and liquidity requirements. A third hurdle to overcome is operational capacity – there are a lot of manual work arounds in the post-trade settlement space and it remains a resource-heavy process.

CL: So what are you doing to help overcome these obstacles and build efficiency levels?

AK: We have a ‘three pillars’ approach. First, there is the elimination of manual processes, second enabling riskless settlement via PvP, and third near-real time settlement.

On eliminating manual processes, we recently extended our FX services with the launch of our Pre-Settlement Matcher, Settlement Monitor, and Liquidity Tracker. The Pre-Settlement Matcher automates communication and the agreement process between counterparties on netted payment values. The Settlement Monitor tracks and reconciles inbound payments, allowing intraday updates on settlement risk, and actual or potential failed settlements. The Liquidity Tracker maintains available account balances and combines them with expected, completed, and pending incoming and outgoing payments.

This is an incremental approach to the issue but while there is undoubted value in this there is also a more fundamental approach that gets the industry to the final destination and that is actually changing the way they settle with their counterparts. If the leaders within the FX industry are prepared to embrace change in process this will allow them to do genuinely risk-free settlement across every currency pair, in real time. That’s our goal and we know that it requires effort and coordination and that’s tough to achieve sometimes, but hopefully people in leadership positions will appreciate this and dedicate the resources.

CL: You spoke on a panel I moderated recently and there was an interesting discussion around real-time settlement, it was pointed out that not everyone wants it.

AK: Absolutely. It doesn’t mean that every trade you do results in an instantaneous settlement necessarily, it means when you elect to settle, whatever it is you’re settling, it is not done at some random point on value date, it is settled very deliberately and very specifically at a given point, with full transparency and legal finality. This could be via a smart contract, where a specific time or event trigger results in that settlement taking place pretty much instantaneously. We think this is much more efficient compared to paying out and getting paid some time on the value date.

CL: What are the roadblocks to getting to this end goal of a more efficient settlement process?

AK: Primarily at the moment there is incomplete data available to people operating in that post-trade space. This creates silos with legacy processes. People get batch data rather than real time data from and across disparate systems. I mentioned earlier about manual processes, many are actually a function of the fact that firms have this incomplete, disparate, disorganised data. If everything was contained and nicely formatted in the same system, many of those manual processes could be got rid of.

Another issue is the uncertainty of status. It’s very difficult to actually know what the status of a specific settlement is, either inbound or outbound in real time or in something close to real time. This is not a specific FX issue either, it happens across markets – even at T+1 it exists.

CL: Which brings us back to the solutions you launched at the end of September.

AK: We help firms aggregate data around their obligations and balances on an intraday basis, real time if it’s available, from multiple sources. We unify, normalise and make the data available for practical use. By pulling together these legacy silos and systems and normalising this data, you end up with a dataset that is current, consistent and which can be used practically. It’s a three-stage process of aggregate, assess and activate.

This process gives customers the right data and once they have that we have a rules engine that allows them to automate alerts, processes and, when needed, decision making. They can then sequence their payments based upon these rules. By connecting the data and the rules to a client’s payments gateway we are then facilitating the movement of whatever the asset might be.

If we are talking FX, bilateral settlement in FX has a lot of those characteristics that inhibit efficient settlement, it has incomplete data, lots of manual processes and uncertainty of status. It’s also expensive, not particularly scalable, and there are a lot of settlements not going through CLS.

Our solutions use a shared permission ledger, but, importantly, we use existing payment rails to settle.

CL: Earlier you mentioned Pre-Settlement Matcher, are you talking netting there?

AK: Netting is a part of it and needs to be a bigger part of the conversation. There are a lot of interbank trades that are not CLS settled and you have to ask why are they not netting these? I suspect they’re not because that would generate another manual process that the banks don’t really feel very comfortable doing. From an operational process perspective, banks think it is simpler to merely queue up those trades and settle gross. Now, in the context of these conversations about settlement risk, you have to ask yourself, is that really the right outcome? Just because it’s operationally simple?

From a broader perspective, firms also struggle to actually agree what their settlement values are with one another. The calculations are not necessarily consistent because some firms want to include certain products or transactions that others want to exclude. Some may say let’s cut off at midnight and others may say let’s cut off at 10 in the morning. There are differences in the calculation methodology and then there are those customers who may want to extract a subset of trades out of a much larger batch because they want to gross settle them. Equally, a real money manager may have two custodians they want to split their settlements across. There is a lot that needs to be agreed and established upfront.

Then of course there’s the actual process of agreeing the settlement values, which by and large both sides should agree as it’s pretty straightforward. There are complexities here also, however, because the trades are being done across multiple channels and messages are coming in from different sources. This leads to a totally fractured set of conversations that go on via multiple channels and while some have tried to harmonise this by promoting new communication protocols as a standard, none have gained critical mass. Something like 50% of all settlement values are agreed via email.

Baton Systems sits in the middle of this process, on behalf of our client banks. We help with the calculation of the netted values to the extent they need it and we also manage the communication with all of the counterparties through all the different channels. We act as a central point, which allows banks to agree settlement values faster and more accurately.

This is a huge efficiency gain because if you are automating these processes then a high percentage of your settlement values and payments are going to be agreed without any manual input and that puts an often overworked operations team on a firmer footing for the rest of the day.

CL: Which is where synchronisation comes in…

AK: Yes. Based on either or both of their settlement risk appetite against specific counterparties or their funding position in the specific currencies, banks can then synchronise or orchestrate their payments. We enable them to reconcile inbound receipts against what they are expecting, and check off in real time what each counterparty has paid in. That then tells the client where they are, vis-a-vis their settlement limit.

With this information they can then also calculate if by making that payment they will remain within their daily settlement limit for that counterparty. If they’re going to exceed it, they can put a brake on the payment and wait for some inbound receipts from that counterparty or, if they are tracking their funding position, in that currency. With the alerts framework, of course, they can also request an approval from a credit officer.

On the funding side, clients can track what their end of day balances look like and what actions they may have to take in the form of lending or borrowing.

CL: There is still likely to be some settlement risk though isn’t there?

AK: There is. There are always going to be exceptions that need investigating, but if clients are netting more and are able to demonstrate to all their stakeholders they have absolute control over the process it is tremendously reduced.

CL: You have mentioned to me previously that a more efficient settlement process can benefit the broader business, can you explain what you mean by that?

AK: Many markets businesses are constrained by settlement risk and by funding, which means there are pockets of business that are simply not getting done and that banks are unable to fully serve as their customers because they don’t have the processes in place that allow them adequately to manage the settlement risk in accordance with the settlement risk limits that their credit officers would like to impose.

So yes, this is not just about collapsing settlement risk, it’s also about growing the market, it’s about growing a business’ footprint. There are still institutions that only take on new business if there is a safe settlement process, in other words, if they can pay out only when they have received in. Operationally these firms are not prepared to assume the settlement risk, and if they don’t have the operational staff to monitor that risk, it is the responsible, risk relevant, decision.

If, however, they can automate a process that allows them to do this, they’re growing their business and are becoming more relevant to their counterparties – and let’s not forget the client experience here. In a safe settlement process how often is the bank checking the funds have been received? Either way it is a bad experience for the client.

CL: How close do you think we are to gaining widespread adoption of this model?

AK: We have a process that has been running with a major global bank for a year now. We started off with internal and back-to-back transactions – distinct legal entities under one umbrella – and we are close to our first external PvP settlements.

More generally, the level of conversation around settlement risk and the presumably increased concern that credit officers rightfully have about it because of the current macro situation with the pandemic means now is the time to strike. We can solve for some real world issues and, into the bargain, help to ease some of the pressure that established capital markets participants now find themselves under from smaller retail based participants offering real time settlement.

CL: And, to go back to your earlier point, this would benefit the entire industry…

AK: Reducing or eliminating settlement risk is such a key focus right now and regulators and other industry stakeholders want to see progress in this area. A successful transition to a more efficient model will serve to break down one of the key barriers to trading relationships, opening up new business channels and preserving existing ones.

On an operational level the implementation of smart contracts allows banks to respond to the demands being made by customers, regulators and central banks alike, and combined with PvP it also opens the way for short-dated – even intraday – FX swaps to be used for funding or liquidity with settlement certainty. There is also increased visibility and control of intraday funding to ensure that banks are able to allocate their financial resources in an optimal manner.

We are talking a solution that enables. Eliminating many of the manual processes around the post-trade process allows firms to be more resilient and to increase their capacity whilst reducing overall costs.