Payment-versus-payment (PvP) is a settlement mechanism that ensures that the final transfer of a payment in one currency occurs only if the final transfer of a payment in another currency or currencies takes place.
In July, the Global Foreign Exchange Committee published the results of a three-year review of the FX global code. Given the potential risks associated with FX settlement, the committee identified a need to strengthen its guidance on settlement risk to place greater emphasis on the usage of PvP settlement mechanisms.
Principle 35 of the code now states that market participants should reduce their settlement risks as much as practicable, including by settling FX transactions through services that provide PvP settlement.
One of the actions highlighted in a June 2020 Financial Stability Board (FSB) report was to encourage observance of existing international guidance on the use of PvP and develop options that could increase its use – as well as understanding of why it might not be used.
Analysis conducted by the Bank for International Settlements (BIS) suggests that the proportion of trades executed with PvP protection has fallen in recent years. According to the BIS, expanding the availability of PvP settlement to a wider range of transactions and actors is an important element in improving payment infrastructures and arrangements for cross-border payments.
This is particularly relevant for currencies that are not eligible for settlement through CLS Group, which covers 18 of the most actively traded currencies and uses PvP. Since June, CLS has been running a pilot scheme with a working group of 12 settlement members, using their trade data to explore potential PvP solutions for these less-liquid currencies.
There are two main value propositions for such a solution. Firstly, mitigation of settlement risk as part of emerging market (EM) currency transactions that are currently settled bilaterally on a free-of-payment basis – where there is a transfer of securities without a corresponding transfer of funds; and secondly, funding/liquidity optimization via optimized bilateral or multilateral netting, and as a result of optimized operational and technological platforms that would reduce fails and client claims.
The bigger opportunity would be a mass-market, lower-cost alternative to CLS
Nick Pedersen, NatWest Markets
At the moment, the initiative is contemplating enhancing CLSNet, its bilateral payment netting service, so that it provides PvP capabilities for four EM currencies: CNH, TRY, RUB and PLN. One of the candidate models under review as part of the initiative contemplates multilateral netting for these currencies, which would theoretically bring material benefits from a funding and liquidity perspective.
The heads of FX at a number of the banks involved in the pilot scheme have spoken of the need for settlement risk practices to evolve as EM FX trading volumes increase.
The FSB’s committee on payments and market infrastructures has been charged with developing proposals for increased adoption of PvP by either encouraging enhancements to existing services or the design of new public or private sector solutions.
Nick Pedersen, global head of digital at NatWest Markets, agrees that alternative solutions could emerge. “The bigger opportunity would be a mass-market, lower-cost alternative to CLS that would bring these settlement benefits to institutions that do not use CLS because of the price tag,” he says.
CLS’s bilateral payment netting calculation service is already available for approximately 120 currencies. However, payment netting and PvP address different challenges, and the impact of PvP for some of the most highly traded non-CLS settled currencies is likely to be significant in reducing settlement risk, notes a spokesperson for Deutsche Bank.
There is also acknowledgement that creating an alternative PvP solution to address the expansion of FX settlement risk to EM currencies will not be a speedy process. Simon Manwaring, global head of trading at NatWest Markets, says it will take time to develop.
One dealer suggests that it is more likely that the current bilateral CLSNet platform will evolve into a PvP system in the short term, with a multilateral netting framework taking longer to emerge.
Pedersen reckons it could be as long as five years before a working service is in operation.
“There is a huge amount of focus on central bank digital currency (CBDC) and it could be imagined that emerging market countries leapfrog traditional settlement systems into these digital currencies,” he says. “This would have an interesting dynamic in enabling PvP settlement, but the practical implications would take many years to unpick.”
