Could intraday FX swaps help reduce settlement risk?

Imagine a bank that knows it will receive dollars early in the morning before having to pay out dollar obligations before the day ends. But say it also knew it would have to make sterling payments around noon before receiving a separate sterling flow a few hours later. It faces a midday mismatch – too many dollars; too few pounds.

The bank could turn to the spot market, exchange excess dollars for pounds, make its dollar payment in the afternoon and then do the transaction in reverse to meet its end-of-day sterling obligation.

But paying transaction costs on two trades and being exposed to intraday price fluctuations could prove expensive. Instead, the bank could use a swap to address its mismatch, with each leg of the trade settling within the day.

The FX market already suffers from fragmentation and users may be wary of increasing its complexity, even in the name of payment certainty

For that to work, the bank would need assurances that its counterparty will make good on those commitments at the expected times. That’s a form of settlement risk – uncertainty around receiving what your counterparty agreed to exchange.

This intraday foreign exchange swap market doesn’t exist yet, but market participants hope that financial technology provider Finteum can fill that void. The firm plans to offer intraday repo and FX swaps facilities and has conducted testing with 19 banks for a go-live date scheduled for later this year.

Initially, the FX swap platform will rely on real-time gross settlement (RTGS) systems to settle swaps and will fine users according to its rule book if they fail to meet their obligations on time. But until the system transitions to payment-versus-payment (PvP) settlement, where one side’s funds transfer if – and only if – the other’s do, participants will still be exposed to some level of settlement risk.

The prospect of intraday swaps is alluring, though, and it has caught the attention of banks, especially given the trades can still be governed by master agreement documentation from the International Swaps and Derivatives Association. And once PvP is up and running, it could potentially draw in flow that previously wasn’t going through CLS as users seek to take advantage of new intraday strategies.

Making the market work will need a fair amount of effort from participants. Banks must understand their intraday funding needs, an effort that requires co-ordinating multiple, likely global, operations to quantify known and estimated payments throughout the day.

The Global Financial Markets Association’s Global Foreign Exchange Division wrote in July that it wasn’t clear there was enough desire or ability to push transactions to tighter settlement windows, citing the magnitude of the effort, the cost, and the co-ordination needed to achieve the goal.

Market participants also point to the challenge of building a network of users big enough to make a single platform or initiative relevant. The FX market already suffers from fragmentation and users may be wary of increasing its complexity, even in the name of payment certainty.

But the market widely understands the advantages of reducing settlement risk, so perhaps a new intraday market is another place to demonstrate that those benefits are worth the effort.