The foreign exchange market is subject to significant credit and settlement risks. While there are risk mitigation mechanisms, about one third of foreign exchange settlements are estimated to take place without them. Ousmène Mandeng writes that the adoption of central bank and other digital currencies can give rise to an entirely new settlement approach, collapsing the foreign exchange life cycle and freeing transactions from credit and settlement risks.

The foreign exchange market is the largest segment of the financial market in the world. It has a daily average turnover of US$7.5 trillion and touches on most aspects of economic activities.

Now, the demand for foreign exchange is affected by the increasingly complicated international economic environment. No other market seems more susceptible to disruption and may benefit more from the inherent properties of digital currencies. Digital currencies facilitate a new settlement approach that could derisk and produce important efficiency gains for the foreign exchange market.

Foreign exchange risks

With high trading volumes and lack of diversification, the foreign exchange market is subject to considerable complexities and risks. Its 10 largest institutions make up two thirds of the transaction volume. Currency concentration is substantial and the US dollar is one side in nine out of 10 currency pairs. There are significant credit and settlement risks. While it’s possible to minimise risks, about one third of foreign exchange settlements are estimated to take place without risk mitigation. Settlement is subject to important delays and normally takes two days from execution but can take considerably longer.

Foreign exchange consists of exchanging two amounts of money, each denominated in a given national currency at a set exchange rate. The foreign exchange life cycle distinguishes normally between execution, netting and settlement. Netting is the consolidation of multiple transactions with other financial institutions, leaving a single net amount to be received or paid out.

To settle a transaction, payments are normally made in the large value payment system (LVPS) of the country whose currency is being exchanged. Because banks typically do not have access to foreign LVPS, they need to make or receive payments using correspondent banks.

Credit risk is addressed by minimising exposure to the counterparty. Banks do it especially via netting, as seen above, and setting aside capital to absorb possible losses. Settlement risk is mitigated by payment-versus-payment mechanisms to ensure monies are exchanged only if both can meet their respective obligations. Risk increases with time to settlement.

CLS, an independent multi-currency settlement system, offers important risk mitigation mechanisms through multilateral netting and payment-versus-payment arrangements. Only 18 currencies can be cleared through CLS. Multilateral netting reduces average funding to merely a small fraction of traded amounts. However, netting itself implies credit exposures and is subject to considerable systemic risk.

Banks hold large amounts of regulatory capital as liquidity buffers to address credit and settlement risks and meet their liquidity coverage ratios (LCRs), a measure of a bank’s ability to meet its short-term obligations. The capital banks hold to meet these obligations in case of distress is called high-quality liquid assets (HQLA). These reserves bear an opportunity cost, calculated as the difference between their rate of return and banks’ target rate of return on equity.

Euro area banks hold about 3.8 trillion euros in HQLA. It is estimated that about 10-30 percent of HQLA are to cover intra-day liquidity shortfalls. The amount allocated to foreign exchange is normally not disclosed but is estimated to be a significant share of intra-day liquidity needs.

Central bank digital currencies

The adoption of digital currencies can give rise to an entirely new settlement approach. Digital currencies shall mean here currencies issued on blockchain in a tokenised format. They can be exchanged like cash, collapsing the foreign exchange life cycle, in which execution is settlement and every transaction is processed on a gross basis. Transactions can settle instantly and atomically, meaning both legs of the transaction have to succeed or none does (payment versus payment).

The combination of central bank digital currencies (CBDC) or other high-quality settlement instruments and instant and atomic settlement implies that foreign exchange transactions are no longer subject to credit and settlement risks.

The use of instant and atomic settlement implies that each bank’s position is always balanced. One leg of the transaction funds the other leg. In an instant environment, there are no delays, and one operation can follow another (nested operations). The bought leg (the currency that is being bought or received) can be traded for another currency (for example in a swap) instantly, thus establishing or restoring the desired currency exposure. The conditions produce an environment where money velocity becomes infinite, producing important liquidity savings.

The implied risk mitigation and liquidity savings are estimated to produce sizable regulatory capital savings. It may represent one the greatest sources of cost reduction for banks. If euro area banks alone were to forgo say 10 per cent on HQLA holdings, it would mean savings of 380 billion euros in regulatory capital.

The reduction in regulatory capital requirements, lower liquidity needs and adoption of gross settlement would produce entirely new market conditions. These factors may enable efficient settlement at lower volumes and could give rise to more competition as lower capital requirements would mean lower transaction costs and lower barriers to entry. This would follow the logic of real-time gross settlement in domestic large value payments.

The introduction of alternative settlement approaches could rebalance the foreign exchange market, reduce concentration and allow smaller currencies to become relatively more attractive. The market would offer efficient settlement at significantly lower levels of concentration and liquidity. This matters particularly for currency pairs that cannot settle via CLS. While the new approaches are not limited to digital currencies, these currencies already hold readily deployable out-of-the-box features that support them.

An alternative settlement approach is strictly about the post-trade process and does not alter existing foreign exchange trading and exchange rate determination. However, adoption of digital currencies should mean they will trade at a premium to existing instruments.

While CBDCs would be ideal, there are other high-quality mediums of exchange. Instant and atomic settlement for Brazilian real-US dollar may be coming soon to a trading venue near you.

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• This blog post represents the views of the author(s), not the position of LSE Business Review or the London School of Economics and Political Science.
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