Banks struggle with real-time FX settlement challenge

By:
Paul Golden
Published on:

In the absence of an industry-wide consensus on faster settlement, availability of real-time FX conversion is likely to remain patchy – challenging the growth of immediate payments in corporate banking.

Immediate payments – already well-established in the consumer-banking market – have the potential to shake up corporate banking, giving corporate treasurers’ liquidity and service-delivery benefits.

However, to enable this, the settlement process for FX transactions needs a transformation, challenging banks’ risk-management and IT systems.

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  As long as conventional spot contracts are settled on a T+2 basis, banks will be precluded…

James O’Neill,
Celent

At present, there is no harmonized push between regulators in the EU and the US to boost the adoption of real-time FX processing and immediate payments – and industry efforts are patchy.

For banks, there is an obvious deterrent to real-time conversion of foreign exchange. With a few exceptions, FX transactions are settled on a T+2 basis. So, if a bank settles the transaction with the client in real time, it takes performance risk on the other side of the transaction if the counterparty to the trade defaults on its obligation to deliver the funds.

In addition, Gary Wright, CEO of BISS Research, an independent research company, reckons there is at least one other reason for the lack of interest in real-time FX conversion from some banks.

"We could talk about the technology question of obtaining the required data, but a more likely explanation is the opportunity to price and make a profit – banks make a huge amount of money on latency [the time it takes process the FX data]," he says.

Wright says there is no technological barrier to the implementation of real-time FX conversion, a view shared by Celent senior analyst James O’Neill, who accepts it is not a technical challenge per se, but more of a function of the settlement risk problem.

"As long as conventional spot contracts are settled on a T+2 basis, banks will be precluded from offering real-time settlement to their corporate clients unless they want to assume the settlement risk and price this into the exchange rate offered to the corporate," he says.

An addition complication, according to Michael Daniels from CGI’s banking division, is that real time is not a standardized term. Most trades are open for 15 minutes, so the other party has 15 minutes to trade at the price quoted. This supports settlement processes, such as obtaining credit approval, processing of deal tickets, etc.

"There are efforts afoot to reduce the open period [five minutes being a proposed standard] as settlement risk is higher during the open period," he says.

Further barriers

Daniels says there are several reasons why banks might be reluctant to offer FX conversion in real time, including: limited demand from clients making the activity uneconomic; lack of effective controls meaning management does not have the risk appetite to support trading; delays in validating counterparties; and lack of credit standing to be accepted as a counterparty.

"There are also some local rules that can add further barriers," says Daniels. "For instance, Japan requires trading to only take place on an approved [Japanese] exchange.

"The size of the deal can also be a factor – for a currency such as the Swedish krona, a $1 billion transaction would distort the market. Hence, any dealer funding such a transaction would choose to build up such a position over several days rather than in a single, real-time trade."

Craig Ramsey, principal product manager, transaction banking, at ACI Worldwide, says many banks are still relying on payments technology created in the 1980s and 1990s, which limits real-time system availability.

"This technology was never expected to support real-time FX rates as, at the time, a rate set early in the trading day was normally sufficient," he says.

Ramsey suggests immediate payments will have a massive impact on FX conversion.

"Although they are largely domestic currency-based now, it is only a matter of time before regional and global schemes come to the market and at that point real-time FX rates will be a must," he says. "Banks must start to adjust their systems in preparation for this."

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Therefore, in principle, it is not a case of whether real-time FX rates will become ubiquitous but when – and that will probably be sooner than many banks expect, adds Ramsey.

"As immediate payments schemes become established around the world, the industry is already looking to see how that can apply across currencies," he says.

However, demand will continue to vary from country to country, says CGI’s Daniels.

Since 2002, continuous linked settlement has been available to participating banks and financial institutions. This effectively processes FX settlement on a simultaneous basis for both sides of a given transaction, taking the settlement risk out of the equation.

"Not all banks participate in this settlement service, but for those that do I suppose it would be possible to offer real-time FX settlement for their clients," concludes Celent’s O’Neill.