Netting plays an important part in mitigating FX settlement risk, reducing both the number and cumulative value of payments made as well as the cash flows and funding requirements for each counterparty. Baton’s Core-FX™ solution allows for configurable, automated, bilateral netting, enabling operational risks to be reduced and the achievement of more impactful management of a firms’ funding and liquidity cycles.
Since the 2019 Bank for International Settlements’ (BIS) Triennial Report¹ there has been increased focus by industry officials on FX settlement risk, with calls for greater adoption of payment-versus-payment (PvP) settlement mechanisms. Netting is recognised as an important factor in the mitigation of settlement risk and the ability to then settle those netted trades on a PvP basis is highly beneficial.
Principle 50 of the FX Global Code (as revised in July 2021²) emphasises the desirability of bilateral netting and the agreement of predetermined cut-off points. More recently still, in May 2022, the Global Foreign Exchange Division (GFXD) of the Global Financial Markets Association (GFMA) published its recommendations for reducing settlement risk³, highlighting the ways in which automated netting can reduce the operational burden and the likelihood of error resulting from manually-intensive processes.
Not only does netting reduce the number of payments being made by the two counterparties to a transaction, thereby decreasing the impact of a settlement default or failure, it also reduces the funding requirements for each counterparty. However, the netting process is used far less frequently than might be expected, and that’s because there’s no agreed approach to netting in the market today. It’s a notoriously resource-heavy process. Each counterparty is probably using either spreadsheets or a vendor-based platform to make its individual calculations and there’s no means to transparently share, interact with and agree to the transactions in a given netting set in real-time.
The need to bring transparency into the netting process is fundamentally important. I’d argue that most banks probably spend more money on tracking down exceptions to their netting sets than they do on any other part of the broader settlement process on any given day.
“The need to bring transparency into the netting process is fundamentally important”
DLT – automating the netting process
Banks now have the opportunity to settle as many of their transactions as possible through an automated and inclusive PvP mechanism. The distributed ledger technology (DLT) behind Baton’s Core-FX™ solution ensures that anything agreed as a trade to be included in the netting set is reconciled across the counterparties, acknowledged and memorialised. Everyone agrees to it. That becomes a golden copy and the amounts arising from those trades in terms of settlement are therefore also agreed and enter directly into the netting set. Once again, each amount is memorialised or notarised within that process as it’s agreed between the counterparties.
“Banks now have the opportunity to settle as many of their transactions as possible through an automated and inclusive PvP mechanism”
The netting sets are confirmed on, or occasionally before, value date. Because Core-FX relies on shared data and workflows, there’s no need for old-style reconciliations or manual processes to agree these values. Therefore reducing the potential for operational risk and increasing the opportunity for firms to scale the volume of netted transactions.
“Because Core-FX relies on shared data and workflows, there’s no need for old-style reconciliations or manual processes to agree these values”
With Core-FX, counterparties can choose to safely settle their netted (and gross transactions, if they so wish) on a PvP basis at whatever time proves optimal for them. At this point, there should be little or no discussion necessary as to the settlement amount, because each time a new trade has been added to that netting set it has been scrutinised and agreed to by the two parties.
Multilateral vs bilateral netting
Both multilateral and bilateral netting have advantages. Multilateral netting by definition implies a batch-based type of settlement process. So while multilateral netting can essentially net down obligations amongst participating settlement counterparties to roughly 99% of what they’ve done during the day, this still has to happen over a 24-hour period (tying up liquidity for an extended period). And we know that even netting that down on a multilateral basis to the 1-2% for a large institution could result in needing to settle $50- $60 billion or equivalent on a gross basis during a trading day, which still means that large amounts of funds are washing through the system.
“Because it’s bilateral, a settlement event can occur while other activity continues”
Bilateral netting, on the other hand, allows for two counterparties to agree that they will capture all the trades in a currency pair, and to settle according to an agreed time of day or at the point that an agreed exposure limit is reached. Because it’s bilateral, a settlement event can occur while other activity continues. So while two counterparties might be involved in a settlement workflow around USD/EUR, they could still be building their netting sets around another currency pair such as USD/GBP. The music doesn’t stop. The participants can continue dancing as they’re settling a part of their overall obligations amongst their counterparties, and we think that’s very important.
“The music doesn’t stop. The participants can continue dancing as they’re settling a part of their overall obligations amongst their counterparties”
The advantages of bilateral netting
Core-FX offers participants the ability to net on a bilateral basis, allowing both counterparties to manage their funding and liquidity cycles much more impactfully. I believe there are two aspects to the value this offers. Firstly, although counterparties still need to position funds for settlement in any given currency, those funds are essentially mobilised for no more than a few minutes rather than for the 24 hours required by existing multilateral settlement processes. These bilaterally netted trades can then be safely settled on a PvP basis.
“Core-FX offers participants the ability to net on a bilateral basis, allowing both counterparties to manage their funding and liquidity cycles much more impactfully”
Once the settlement process is finished, both parties can recycle those funds for use elsewhere. This results in a much more dynamic recycling of funding resources over the course of any given day as settling counterparties can then decide to move ahead and settle other obligations they have in other currency pairs.
“This results in a much more dynamic recycling of funding resources over the course of any given day as settling counterparties can then decide to move ahead and settle other obligations they have in other currency pairs”
The second advantage is that bilateral netting allows settlement participants to settle at times which, from their perspective, represent optimal liquidity profiles for the particular currencies that they are settling in. This avoids the need to force a large amount of settlement in a particular currency at a specific point during the day and acts in the broader interests of market participants and, ultimately, of market liquidity.
I hope that you have found this blog useful in explaining the role netting plays in achieving safer FX settlement. If you have any questions or would like to learn more about Baton Core-FX please don’t hesitate to reach out to me at [email protected]
¹ https://www.bis.org/publ/qtrpdf/r_qt1912x.htm
² https://www.globalfxc.org/docs/fx_global.pdf
³ https://www.gfma.org/wp-content/uploads/2022/05/reducing-settlement-risk-may-2022.pdf