FX settlement risk: good news at last

On average, a total solar eclipse is visible somewhere on Earth every 18 months. The astronomical phenomenon occurs when our planet, the moon and the sun are perfectly aligned with each other – a rare but not impossible event. 

Every now and then, the key players in the financial and regulatory space also align, albeit on a much smaller scale and with far less fanfare. When this happens – and it concerns as serious a topic as settlement risk rising in foreign exchange – the opportunity shouldn’t be wasted. 

First flagged as a growing systemic risk by the Bank for International Settlements in December 2019, the market has since begun to take stock of ways to solve the problem, or at least try to reduce it. 

CLS – the industry utility put in charge of tackling the issue almost 20 years ago – acknowledged the challenge and began working on a proposal to create a stripped-back system for emerging market currencies. A number of dealers and non-banks that spoke with FX Markets for last month’s cover story called for CLS to open up its doors and allow a wider range of participants to join. 

However, CLS’s legal foundations limit the type of market participant eligible to join its main service – CLSSettlement – thus reducing its scope in tackling settlement risk. 

“We cannot widen membership to CLSSettlement beyond those defined categories as the rules are implemented under the law,” says Alan Marquard, chief business development officer at CLS.

The good news is that help might be on the way. The European Commission is due to launch a public consultation on the EU’s Settlement Finality Directive – the law that regulates the systems used to transfer financial instruments and payments, including CLS.  

While details of the consultation’s contents are not yet public, the move has the potential to close some of the gaps currently preventing CLS from onboarding new types of entity as members. 

The road to achieving this is still long, and there are many legislative hurdles to clear. But in less than 12 months, the players involved in either monitoring or addressing settlement risk have set the wheels in motion to tackle this growing concern. 

And while there are a lot of moving parts in play, the direction of travel is clear. The results might not be as exciting as a solar eclipse, but their impact on the FX system could be a welcome development.