FX settlement risk has increased since 2013 according to the Bank for International Settlements (BIS), both in relative and absolute terms, however the gross market value of outstanding FX and OTC derivatives has fallen, thanks largely to the growth in clearing.
An article in the bank’s latest Quarterly Review says that in spite of “significant progress” in reducing FX settlement risk over the past two decades, and due in part to higher trading activity, the 2019 BIS Triennial Survey indicates that close to $9 trillion of payments remain at risk on any given day.
The report does highlight how the establishment of CLS and other actions led to a big reduction in FX settlement risk and that even at the height of the great financial crisis, FX markets remained resilient, however, thanks to expanded data collation in the latest FX turnover survey, the BIS feels it has identified the scale of the challenge still facing markets.
To help assess progress in reducing FX settlement risk, the BIS survey was expanded in 2019 to collect data on FX settlement. After taking account of the number of payments for each instrument, in April 2019 daily global FX trading of $6.6 trillion translated into gross payment obligations worth $18.7 trillion, it says, adding that bilateral netting reduced the payment obligations to $15.2 trillion.
About $6.3 trillion was settled on a PvP basis using CLS or a similar settlement system, which left an estimated $8.9 trillion worth of FX payments at risk on any given day. The proportion of trades with PvP protection appears to have fallen from 50% in 2013 to 40% in 2019, although available data are not fully comparable across time due to different reporting methods.
The report highlights the most likely reason for this increases in settlement risk – namely the growth in trading for non-CLS eligible currencies that was seen in the latest survey. In absolute terms, the report says that 90% of FX settlement risk is in the top 10 jurisdictions, however, these advanced economies settle a higher proportion of their FX with PvP protection than emerging market economies do, many of which have currencies that are not included in CLS. Nonetheless, it continues, CLS-eligible currency pairs still make up about 80% of total global trading activity. “To reduce global risk, it may therefore be necessary to both encourage FX market participants to use PvP where available and widen that availability to include EME currencies,” the report states. “The task of reducing global risk is now firmly on the agenda of bank supervisors.”
But Outstanding Exposures are Down
The marked pickup in the trading of FX and OTC derivatives between the 2016 and 2019 BIS surveys did not lead to an increase in outstanding exposures, the latest Quarterly Report from the BIS finds. “To be sure, since 2015 the notional principal of outstanding OTC derivatives has trended upwards, and at end-June 2019 it reached its highest level since 2014,” it states. “However, their gross market value – a more meaningful measure of amounts at risk than notional principal – has trended downward since 2012.”
The gross market value was $12 trillion at end-June 2019, close to its level immediately before the GFC.
Compression and clearing helped to slow the growth of outstanding exposures, the report says, explaining that compression eliminates economically redundant derivatives positions and thereby reduces outstanding contracts. Compression first took hold in the market for credit default swaps (CDS), where even before the GFC it contributed to a sharp reduction in notional principal. While it took longer to penetrate OTC interest rate derivatives markets, the frequency and amount of compression has increased in recent years, making it now commonplace, the report states, adding, “Compression, coupled with electronification and other changes, is reshaping OTC markets along the lines of exchanges.”
The report continues by noting that compression has been “greatly facilitated” by the expansion of central clearing. Clearing rates for CDS and OTC interest rate derivatives rose steadily between 2010 and 2017, though they have since levelled off. By 2019, derivatives subject to mandatory clearing, mainly forward rate agreements, interest rate swaps and CDS indices, were almost all centrally cleared. The report finds that, among derivatives not subject to mandatory clearing, some have migrated to central clearing voluntarily and that the decision whether to migrate contracts depends on the benefits of lower margin requirements, potential gains from netting positions within the same asset class and relative liquidity conditions.
It is not all good news, however, for the report also states that in contrast to trends in other segments of OTC markets, in FX markets initiatives to mitigate risk exposures appear to have stalled, hence why settlement risk is a major concern.