NIFD and CLS Joint Forum Publication:

Foreign Exchange Market Infrastructure to Support

Stability of RMB Internationally

13th September 2017

All views or opinions expressed in this document are CLS’s and do not reflect the position of any other organization. The information included herein does not constitute investment or financial advice and should not be relied upon as such. This document is for the exclusive use of the recipient and may not be quoted, forwarded, copied or shared, in whole or in part, without the prior written permission of CLS Group.

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Contents Abstract/Executive Summary .................................................................................................... 3

1 Introduction ....................................................................................................................... 4

The importance of China to the global economy ...................................................... 4 1.1

1.1.1 Global Trade ...................................................................................................... 4

1.1.2 FDI/ODI .............................................................................................................. 5

1.1.3 Portfolio investment .......................................................................................... 5

Financial markets integration and the importance of a well-developed FX market . 6 1.2

2 The global FX market ......................................................................................................... 8

Primary FX trading locations and offshore trading ................................................. 10 2.1

Key Risks in FX.......................................................................................................... 11 2.2

2.2.1 Replacement cost risk ...................................................................................... 12

2.2.2 Principal risk .................................................................................................... 12

2.2.3 Liquidity risk ..................................................................................................... 14

2.2.4 Operational risk ............................................................................................... 14

2.2.5 Legal risk .......................................................................................................... 14

3 International regulatory standards ................................................................................. 14

Bank for International Settlements Committee on Payments and Market 3.1Infrastructures (CPMI) ......................................................................................................... 15

CPSS (now CPMI) and IOSCO Principles for financial market infrastructures (PFMI)3.2 16

Guidelines on managing risks in relation to settlement of FX transactions ............ 17 3.3

3.3.1 Replacement cost risk ...................................................................................... 17

3.3.2 Principal risk .................................................................................................... 17

3.3.3 Liquidity Risk .................................................................................................... 18

3.3.4 Operational risk ............................................................................................... 18

3.3.5 Legal risk .......................................................................................................... 18

The FX Global Code .................................................................................................. 19 3.4

4 Impact of currency activity on risk profiles ..................................................................... 19

Risk practices designed to monitor and limit counterparty risk ............................. 20 4.1

4.1.1 Counterparty limit management under PvP settlement ................................. 20

4.1.2 Counterparty limit management under Non-PvP settlement ......................... 21

Risk management challenges during periods of market stress and volatility ......... 21 4.2

4.2.1 A study of increased risk exposures on peak FX trading days ......................... 21

4.2.2 A study of counterparty risk limit impact during two different currency market events 24

4.2.3 A study of Brexit events and impact on volatility ............................................ 26

Liquidity pressures’ impact on risk limits ................................................................ 29 4.3

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5 Options for FX settlement risk mitigation ....................................................................... 29

Non-payment versus payment settlement and the use of collateral and netting .. 30 5.1

Standardized and enforceable legal agreements .................................................... 32 5.2

Payment-versus-payment settlement ..................................................................... 32 5.3

5.3.1 Central bank funds versus commercial bank funds ......................................... 33

Binding constraints in RMB FX market .................................................................... 33 5.4

5.4.1 Constraints associated with bilateral netting .................................................. 35

6 Settlement risk mitigation through RTGS connectivity ................................................... 36

Domestic payments ................................................................................................. 36 6.1

Risk considerations for cross-border payments ...................................................... 38 6.2

6.2.1 Differences in time zones ................................................................................ 39

6.2.2 Differences in RTGS systems, operational and messaging standards ............. 39

6.2.3 Differences in legal systems ............................................................................ 40

7 Importance of FX settlement risk mitigation to China and the renminbi ....................... 41

China’s risk profile as it continues global financial integration ............................... 41 7.1

The impact of global investor perspectives and international practices ................ 41 7.2

Importance of infrastructure support to China’s financial markets and the renminbi7.3 43

Appendix A: Daily foreign exchange activity following Brexit ................................................. 45

Appendix B: Counterparty exposure calculations ................................................................... 47

Description of CLS data........................................................................................................ 47

Calculation methodology .................................................................................................... 48

Appendix C: Peak-average ratios for different currencies ...................................................... 49

Appendix D: Crossed market example .................................................................................... 51

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Abstract/Executive Summary

This paper identifies considerations relating to the growing exposures and inherent risks in

the FX markets and when financial institutions are involved in cross border payment

processes required to support global trade and investment activities. The implications of

continued global integration of Chinese financial markets and participation of Chinese

financial institutions in global systems are considered and the status of the renminbi in the

global foreign exchange (FX) market, based on Bank for International Settlements (BIS)

Triennial Central Bank surveys, is reviewed.

An analysis of the aggregated, executed FX trade data from CLS Bank International (CLS)

highlights the growing risks China faces as this global integration and participation continues.

The CLS data demonstrates that counterparty exposures can be multiple times greater on a

peak day compared to regular daily market operations. In addition, global events such as the

Brexit vote are examined as they can lead to market volatility and an increase in FX trading

activity, which can result in potential stresses on counterparty risk limits and market

liquidity.

As the FX market has inherent and unique risks in light of the need to make payments across

different jurisdictions and payment systems, the differences between domestic and cross-

border payment processes are highlighted, including risks arising from differences in time-

zones, processes, standards and legal frameworks of different real time gross settlement

payment systems.

The paper explores the international regulatory standards for FX market infrastructures and

adopted best practices, set out by the Basel Committee on Banking Supervision (BCBS) for

banks, which seek to mitigate FX settlement risk i.e. principally through the mechanism of

payment-versus-payment (PvP) and the principles of good practice in the FX market set out

in the recent FX Global Code. As the FX exposures on a peak day can exceed the entire

capital of a bank , it is critically important that, in line with global risk management

standards, financial market infrastructure are in place to mitigate risk arising from FX

settlement, should a bank/counterparty fail in any jurisdiction. The corresponding benefits

and implications to China’s global financial growth and stability in mitigating these FX risks

are discussed in this paper.

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1 Introduction

This paper introduces the foreign exchange (FX) market, its importance to China’s domestic

and global financial development, and the need to mitigate FX settlement related risk, which

arises from cross-border payments. In particular, the paper addresses the largest risk in

foreign exchange, being the potential loss of principal (commonly referred to as settlement

risk).

For the safe and efficient settlement of FX trades, national payment and settlement systems

play a vital role. The lack of necessary coordination to transact cross-border FX payments

across different payment systems, different legal jurisdictions and multiple time zones

introduces risks to the global and local markets that may potentially disrupt global and

domestic financial stability.

This paper will examine some of the important considerations for risk mitigation that should

to be addressed to support cross border trade and investment with China and the

international use of the renminbi (RMB), leveraging data and experience of market

practitioners in the developed investment currencies and markets to illustrate the relevance

and importance to Chinese financial institutions and China’s policy development.

The importance of China to the global economy 1.1

Since 1980, China’s economic growth rate has been significant.1 It has become the world’s

largest manufacturing economy, the largest exporter of goods2, and has one of the fastest

growing consumer markets. The recognition of China’s importance to the global economy is

evident by its contribution to global GDP, estimated to be 18% of global GDP (based on

Purchase power parity).3

China’s continued internationalisation, its sustained growth and significance to the global

economy has and will continue to generate significant demands in foreign exchange for

domestic and international entities wishing to trade and invest in China. This is relevant

from three perspectives: trade, foreign or overseas direct investment (FDI/ODI) or and

portfolio investment.

1.1.1 Global Trade

With respect to domestic Chinese entities, China’s global trade has already and will continue

to provide opportunities for companies to grow their customer and business bases to serve

more markets and customers globally. It may enable Chinese entities to become global and

to expand into overseas markets. These enterprises will need to establish capital and 1 https://www.worldbank.org

2 http://wits.worldbank.org/countrystats.aspx?lang=en

3 https://www.weforum.org/agenda/2016/09/why-china-is-central-to-global-growth

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operating expense bases in local currencies, exposing them to exchange rate risks (market or

replacement cost risk) which will require transactions and hedging activities in RMB and the

counter currencies. Chinese banks have already started to develop global strategies to

support their customers internationally and to support China’s global development. These

developments will fuel continued growth in FX trading by subsidiaries and branches of the

banks in relation to the banks’ own activities as well as to support customers’ activities in

multiple jurisdictions and currencies.

1.1.2 FDI/ODI

China’s growth has attracted interest from foreign investors and businesses. The demand

from other nations for direct investment in China’s growing economy and investment

projects (through FDI) will continue to drive global demand for currency trading in the FX

markets and contribute to the increased use of the renminbi. Conversely, the expansion of

China’s role in the global economy, such as through the One Belt One Road initiatives

(OBOR), will drive an increase in China’s overseas direct investment. Both domestic Chinese

and foreign companies and investors will need to exchange the renminbi or their base

currency respectively for alternate currencies in order to execute business transactions. This

will include the need to mitigate exchange rate risk through hedging activities, as both

domestic and foreign entities will be exposed to increased exchange rate movements. This

risk is mitigated commonly through FX forwards, swaps or other derivatives to manage

exposures, as well as to protect capital from exchange rate losses.

1.1.3 Portfolio investment

From the portfolio investment perspective, there are additional factors that will drive

increased investment in Chinese assets and overseas portfolio investment activity. Investors

will continue to seek opportunities to balance their portfolio exposures in line with the

importance of China’s economy and capital markets in relation to the rest of the world.

Investors will seek to address the imbalance in weighting of their portfolio assets relative to

China’s share of the global economy. As at December 2016, global investors are estimated

to have exposure to Chinese assets at the ratio of 1.5% of China’s gross domestic product

(GDP). This is significantly underweight in comparison the size of China’s capital markets and

global share of GDP. Conversely, China’s investment ratios are also underweight in overseas

assets. As the capital account is further liberalised and investment flows develop both ways

in accordance with a more market based economy, these investment flows will drive the

need for more FX trades in order to settle cross border transactions as well as to manage the

exchange rate exposures (market risk) to these portfolios.

It is within this context of economic growth and significant increases in cross border activity,

driven by China’s continued development, that this paper examines the risks inherent in the

FX markets, which domestic and international investors rely on and are exposed to, and the

supporting infrastructure that mitigate key risks.

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Financial markets integration and the importance of a well-developed FX 1.2

market

The internationalisation of the renminbi is important for China’s international economic

development and forms part of its policy as the country continues to deepen reforms and

broaden its international reach. Data from the Bank for International Settlements (BIS)

Triennial Central Bank surveys (see Table 2.1) for FX turnover and from SWIFT on global

payments for trade (see Figure 1.1) already highlight the growing global use of the renminbi.

Figure 1.1: RMB share of international payments and rank. Source: SWIFT.

China has been proactive in promoting the opening up of the Chinese market and facilitating

the use of the renminbi through various cross-border projects and initiatives, including the

OBOR, the establishment of the Asian Infrastructure Investment Bank (AIIB), and the launch

of Stock Connects (Shanghai-Hong Kong stock connect launched in November 2014 and

Shenzhen-Hong Kong stock connect launched in December 2016) and Bond Connect and

participation of the renminbi in the International Monetary Fund (IMF) Special Drawing

Rights (SDR) basket.

The OBOR initiative was unveiled in 2013. Related Chinese investments have, to date,

totalled USD 60 billion with an announcement in May 2017 that a further USD 600 to USD

800 billion will be invested over the next five years.4 In the Belt and Road forum in May

2017, President Xi Jinping pledged approximately USD 15 billion [sic RMB 100bn] into the Silk

Road Fund to support the trade network building and infrastructure projects along the OBOR

route in addition to about USD 57 billion [sic RMB 380bn] loans from The China

Development Bank and Export Import Bank of China for OBOR infrastructure projects,

production capacity, and financial cooperation. Further investment is expected from

4 http://uk.reuters.com/article/us-china-silkroad-investment-idUKKBN1880ME

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financial institutions, which would be encouraged to expand their overseas renminbi fund

business. The OBOR initiative is one of a number of initiatives that will deepen regional

relations, support investment in developing infrastructure, and promote growth and trading

with China, thus creating favourable conditions for the international use of the renminbi and

growth in cross border activity by Chinese financial institutions.

The Bond Connect scheme (northbound between Hong Kong and China) was launched on

July 3, 2017, which links China's USD 9 trillion bond market with overseas investors. Under

Bond Connect, foreign investors can enter the Chinese interbank bond market via Hong Kong

Exchange. The move of opening up the bond market is consistent with one of the Chinese

government's key goals, namely to integrate the Chinese financial system into the broader

global financial system.

Following the announcement on November 30, 2015 by the IMF recommending the

inclusion of the renminbi into the SDR basket, which commenced on October 1, 2016,

central bank reserves in the renminbi have grown.5 As an example, by the first half of 2017,

the European Central Bank (ECB) completed an investment equivalent to EUR 500 million of

its foreign reserves in renminbi - so far the ECB’s foreign reserves includes US dollar,

Japanese yen, Chinese renminbi, gold and SDRs.6 The investment signifies the importance of

China as an key trading partner with the euro zone.

These initiatives as well as others will likely enhance the position of the renminbi in

international financial transactions and draw greater demand for renminbi for capital

finance and trading.7 The internationalisation of a currency is commonly considered to have

been achieved when the currency is widely used amongst residents and non-residents

domestically and abroad for purchase of trade (goods or services) or investment.8 These

views are supported by various studies which have offered definitions for an international

currency. Many focus on the degree to which a currency is used “outside its home country or

issuing area” (Chinn and Frankel, 2007; ECB, 2007). Some authors define an international

currency as one that is used in “international transactions” (Kannan, 2007) or, more

specifically, that is used “outside its home country by non-residents for transactions with

residents of the home country or with residents of third countries” (Lim, 2006).

Currency internationalisation is in part driven by global demand, by foreign direct investors

and traders who require foreign exchange transactions to support underlying trade and

investment activities across borders. A higher degree of global financial integration could

potentially be achieved if a country’s capital controls are relaxed, which would facilitate

foreign investment but can also lead to increased exposure to fluctuations associated with

5 International Monetary Fund, Currency Composition of Official Foreign Exchange Reserves (COFER) at

data.imf.org 6 European Central Bank Official Website, June 13, 2017

7 International Monetary Institute, Renmin University of China, “RMB Internationalisation Report 2017:

Strengthen the Financial Transaction Function of RMB”, July 2017. 8 Kenen, P. B., “Currency internationalisation: an overview”, Bank for International Settlements, March 2009,

http://www.bis.org/repofficepubl/arpresearch200903.01.pdf

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capital flows.9 However, the premature opening of the capital account can pose risks to a

domestic financial market if not supported by adequate financial regulation, supervision and

infrastructure.10 It is worth noting that a BIS report, authored by Kenen8 pointed out that the

success of the Australian bond market was facilitated by the existence of a well-developed

foreign exchange market.

The benefits and costs of currency internationalisation have already been covered

extensively in literature (examples include: Cohen, B.J.,11 McCauley, R.,12 Kenen, P.B.,8 and

Tao, G.13). This paper assumes continued currency internationalisation of the renminbi and

focuses on some of the requirements for a well-developed FX market including a focus on

risk mitigation. The paper identifies some of the potential risks and causes involved in cross-

border transactions and implications for the Chinese and global financial markets. This is of

particular relevance to China as authorities continue to propose capital market reform

initiatives that will drive growth in renminbi currency trading and global FX markets.

2 The global FX market

Global financial market activity in most asset classes (e.g. equities, bonds and commodities)

requires the exchange of value across jurisdictions. This in turn requires foreign exchange

trading and settlement to facilitate cross border activity. The orderly functioning of capital

markets and cross border development is dependent on the smooth functioning of FX

market trading and settlement.

The FX market trades currencies between buyers and sellers, allowing participants to

exchange one form of currency for another, for example U.S. dollars (USD) in exchange for

renminbi. Exchanging currencies facilitates cross-border transactions, including payments

for goods and services, funds productive investments such as bond investments and

manufacturing, and serves the real economy. Additionally, the FX market allows

corporations and others to reduce their foreign currency exchange rate risks and exposures

through hedging.14

9 Ayhan Kose, M. and Prasad, E.S., “Capital Accounts: Liberalize or Not?”, International Monetary Fund, July 2017

10 Guy Debelle, Assistant Governor (Financial Markets) of the Reserve Bank of Australia, “Developments in Global

FX Markets and Challenges in Currency Internationalisation from an Australian Perspective”, keynote speech presented at the CLS/ASIFMA RMB FX Forum, May 2016 http://rba.gov.au/speeches/2016/sp-ag-2016-05-18.html#5 11

Cohen, B.J., “The Benefits and Costs of an International Currency: Getting the Calculus Right”, Springer, Open Economics Review, Volume 21, No. 1 12

McCauley, R., “Internationalising a currency: the case of the Australian dollar”, Bank for International Settlements, Quarterly Review, December 2006. 13

Tao, G., “RMB Internationalisation at Half-time: Retrospective and Prospect”, CF40, presented at The Asian Financial Leaders Program, May 2017 14

A typical example of how FX markets use hedging to reduce risk relates to the protection of revenues and profits of an exporting firm. A Chinese manufacturing firm exports its goods to a U.S. company, and expects to receive payment in USD. Once it receives the USD payment from the U.S. company it can exchange the payment into RMB. But, it may take time for the payment to be received and the exchange rate between the RMB and the USD may change. Should the value of the RMB increase against the USD during that time, the value of the USD payment could decline, thereby negatively impacting revenues and profits. To avoid that risk, the Chinese

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The FX market has grown to become the world’s largest and most liquid financial market

with daily trading values averaging USD 5.1 trillion in April 201615 according to the latest BIS

report.16 This is in line with the growth in global trade and cross-border investment. Table

2.1 depicts long-term growth and distribution across the most actively traded currencies.

Table 2.1: Global FX turnover for the top 10 currencies since 1995

(based on 2016 BIS survey data)

(a) Absolute value

(daily average in billions of USD) 1998 2001 2004 2007 2010 2013 2016

U.S. dollar (USD) 1,325 1,114 1,702 2,845 3,370 4,661 4,458

Euro (EUR) - 470 724 1,231 1,551 1,789 1,591

Japanese yen (JPY) 332 292 403 573 754 1,234 1,097

British pound (GBP) 168 162 319 494 511 633 650

Australian dollar (AUD) 46 54 116 220 301 463 353

Canadian dollar (CAD) 54 56 81 143 210 244 261

Swiss franc (CHF) 108 74 117 227 250 276 243

Chinese renminbi (CNY) 0 0 2 15 34 120 202

Swedish krona (SEK) 5 31 42 90 87 94 113

Mexican peso (MXN) 7 10 21 44 50 135 112

Other currencies 1,009 215 341 766 824 1,061 1,096

Total * 1,527 1,239 1,934 3,324 3,971 5,355 5,088

* Two currencies are involved in each FX trade, totaling the value traded in individual currencies doubles

the total.

(b) Annualized year-on-year growth rate

(YoY change) 1998 2001 2004 2007 2010 2013 2016

U.S. dollar (USD) - -6% 15% 19% 6% 11% -1%

Euro (EUR) - 15% 19% 8% 5% -4%

Japanese yen (JPY) - -4% 11% 12% 10% 18% -4%

British pound (GBP) - -1% 25% 16% 1% 7% 1%

Australian dollar (AUD) - 5% 29% 24% 11% 15% -9%

Canadian dollar (CAD) - 1% 13% 21% 14% 5% 2%

Swiss franc (CHF) - -12% 16% 25% 3% 3% -4%

Chinese renminbi (CNY) - 96% 31% 52% 19%

Swedish krona (SEK) - 84% 11% 29% -1% 3% 6%

Mexican peso (MXN) - 13% 28% 28% 4% 39% -6%

Other currencies - -40% 17% 31% 2% 9% 1%

Total - -7% 16% 20% 6% 10% -2%

The U.S. dollar (USD) is the most widely traded currency and accounts for 88% of all global

FX transactions. When counting one side of a trade, the BIS report highlights the USD

manufacturing company could engage in a transaction through its banks to reduce the risk – hedge against a possible reduction in value received in the overseas payment. 15

The Triennial Survey is coordinated by the BIS under the auspices of the Markets Committee (for the FX part) and the Committee on the Global Financial System (for the interest rate derivatives part). It is supported through the Data Gaps Initiative endorsed by the G20. 16

The latest BIS survey of FX turnover took place in April 2016. Central banks and other authorities in 52 jurisdictions participated in the 2016 survey (see page 15). They collected data from close to 1,300 banks and other dealers in their jurisdictions and reported national aggregates to the BIS, which then calculated global aggregates. Henceforth, references are made to the 2016 BIS study.

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currency is 44% of the global FX turnover (i.e. a base of 100%). However, in order to analyse

values in all currency pairs traded, both sides are counted (as reported in Table 2.1(a) above)

and thus the USD is involved in 88% of transactions (i.e. a base of 200%). The top currency

pairs, in terms of traded value, as reported by the BIS, are the USD/EUR (23%), USD/JPY

(18%), USD/GBP (9%), USD/AUD (5%), USD/CAD (4%), and USD/CNY (4%).

Among all the currencies the renminbi (onshore and offshore) has grown most rapidly:

between 1998 and 2016, the average daily value traded in CNY increased from a relatively

small value to USD 202 billion as internationalisation policy reforms were implemented.

Primary FX trading locations and offshore trading 2.1

The largest participants in the FX market are financial institutions i.e. bank or investment

institution, that trade either on behalf of their clients (as agents) or as a principal

counterparty. According to the 2016 BIS triennial survey data, 65% of FX turnover was

traded outside the currency’s home jurisdiction.17

London has become the most established and largest centre for FX trading because of its

geographic location (see Table 2.2), which overlaps the APAC and Americas’ time zones.

Markets in London open before the Asian markets close for the day and close after the U.S.

markets open. This allows traders in London to trade across the entire globe. Apart from

London, New York, Singapore, Hong Kong and Japan are considered to be the locations

where most FX is traded. Table 2.2 provides the global geographic distribution of FX trading

by location.

Table 2.2: FX turnover by trade location according to the 2016 BIS triennial survey.

Country Proportion of global FX

turnover (%)

Proportion of RMB FX

turnover (%)

United Kingdom 37 15

United States 19 10

Singapore 8 17

Hong Kong SAR 7 30

Japan 6 1

China 1 22

Others 22 5

Total 100 100

Table 2.3 summarises data from the BIS triennial survey, reporting the top 5 currencies

traded and the proportion of trading offshore. Many currencies, including the renminbi, are

predominantly traded offshore. In 2016 approximately 78% of the renminbi was traded

offshore in locations that include Hong Kong SAR (30% of total renminbi FX turnover),

reflecting its depth of liquidity and local market knowledge, Singapore (17%), U.K. (15%), and

17

The Bank of International Settlements, “Triennial Central Bank Survey: Foreign exchange turnover in April 2016”, September 2016, page 12. http://www.bis.org/publ/rpfx16fx.pdf

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the U.S. (10%). Conversely the British pound is the only top 10 currency largely traded

onshore, which is reflective of the unique role of London, acknowledged as the global

trading hub for FX.

Table 2.3: Top 5 currencies by FX turnover and their proportion traded offshore compared

to the renminbi.

Currency (code) Proportion of

currency traded

offshore (%)

Renminbi (RMB) 78

U.S. dollar (USD) 81

Euro (EUR) 85

Japanese yen (JPY) 78

British pound (GBP) 50

Australian dollar (AUD) 88

Given that a considerable portion of the renminbi trading occurs outside of mainland China,

the payment for a renminbi based FX trade – either the foreign currency leg or the renminbi

leg – will likely involve cross-border payment flows, across different national payment and

settlement systems.

Key Risks in FX 2.2

Recognizing that risk associated with the settlement of FX transactions is significant and has

long been a concern of banking supervisors and central banks, the Basel Committee on

Banking Supervision (BCBS) published Supervisory guidance for managing risks associated

with the settlement of foreign exchange transactions (BCBS Global Supervisory Guidelines) in

February 2013. It identified (i) replacement cost risk (also known as pre-settlement or

market risk), (ii) principal risk (also known as Herstatt risk18), (iii) liquidity risk, (iv)

operational risk and (v) legal risk as the most significant risks associated with FX transactions.

When trading institutions carry out an FX transaction, they are exposed to all of these risks.

As the identification and response to risks in the Chinese financial system is a priority of the

Chinese government19, the paper highlights these areas of risk, particularly replacement cost

and settlement risk, which are expected to increase as China integrates further into the

global financial system, and further developments occur in the liberalisation of the capital

account. 18

Herstatt risk is named after the infamous failure of Bankhaus Herstatt in 1974. Regulators closed, and subsequently put into bankruptcy, the German bank on 26

th June at 15:30 CET in Frankfurt after the interbank

payment system closed in Germany. Given the differences in time zones, the bank was closed at 10:30 EST in New York. The FX counterparts of Bankhaus Herstatt had all paid their Deutsche marks to Bankhaus Herstatt but never received their purchased USD. With the bankruptcy all the counterparties to Bankhaus Herstatt lost the total value of their FX trades. 19

To reduce financial risk a new cabinet committee has been given the responsibility for coordinating financial development and regulation. The committee will improve risk monitoring, early-warning mechanisms, coordinate risk prevention and deal with structural and systemic issues. Source http://chinadaily.com.cn/business/2017-08/04/content_30347347.htm

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2.2.1 Replacement cost risk

All entities involved in cross border transactions, may be required to exchange one currency

for another and are thus exposed to the increase or decrease in the value of the underlying

investment or costs of funding due to exchange rate movements. These exposures are often

managed and mitigated through hedging in the FX markets. In the event of an unsettled FX

transaction with a counterparty, the participant is exposed to the risk of loss equivalent to

the cost of replacing the original transaction at current market prices. This is known as

replacement cost risk.

As outlined in Section 1.1, growth in Chinese trade, foreign and overseas direct investment

as well as portfolio investment activities are expected to increase. As China moves toward a

more market driven financial market structure and toward further liberalisation of the

capital account, the transference of market risk will move from the central government and

central bank to broader market participants. This is a natural evolution of a developing

financial system and requires market participants to assume the responsibility for managing

these risks.

As the Chinese financial system grows and integrates further into the global financial system,

the currency and all capital market participants will be exposed to the need to actively

manage exchange rate movements and risks. This will drive an increased scope and scale of

hedging and FX activity and in turn, increased exposure by financial market participants,

including Chinese institutions, to market risk. The implications of exchange rate activity in

the FX markets, the potential for volatility and the scale of these potential movements are

discussed in Section 4. In addition to normal market adjustments in relative values of

currencies that play out in the global FX markets, events, such as significant political or

economic events may give rise to periods of pronounced and protracted exchange rate

volatility that in turn increases market or replacement cost risk that requires management

and mitigation by market participants.

A number of options and practices for market risk mitigation are noted, and discussed

further in sections 3 and 5.

2.2.2 Principal risk

Principal risk is widely acknowledged as the most important risk in foreign currency trading20. It is defined by the BIS as “the risk of outright loss of the full value of a transaction resulting from the counterparty’s failure to settle”. Principal risk can arise from paying away the currency being sold, but failing to receive the currency being bought. (Also referred to as “Herstatt risk”)”.21

20

See Bank for International Settlements, CPSS “Settlement Risk in Foreign Exchange Transactions”, March 1996 at Section 1.1.1, page 1. 21

BCBS, “Supervisory guidance for managing risks associated with the settlement of foreign exchange transactions”, February 2013. Definitions for: Principal risk, page 35; Liquidity risk, page 34; Operational risk, page 35; Legal risk, page 34.

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Regulatory reports note that the accumulation of FX trades with counterparties can lead to

significant exposures to a single counterparty on a daily basis, which can exceed the entire

capital of the bank22 on a peak day. A study of aggregated, executed data from CLS23

provides evidence to the size of the exposures particularly the increase on peak days and

potential settlement in the global markets (see Table 2.4).

Table 2.4: Counterparty peaks – gross settlement value for FX between counterparties for

currencies settled24 in CLS in Q2 2015.

(A) Average daily

gross settled in

(USD bn)

(B) Peak day gross

settled in

(USD bn)

(C) Increase from

average day to peak

day (%)

Maximum exposure

to counterparty 64.9 163.1 151.3

Average exposure to

counterparty 1.7 7.1 317.6

The data in Table 2.4 is based on CLS data, drawn from settlement of FX instructions from

over 60 of the largest financial and trading institutions globally and over 23,000 third party

institutions which represent some of the biggest investment institutions globally. The data

shows that the average bilateral counterparty exposure in Q2 2015, was USD 1.7bn on an

average day which increased to USD 7.1bn on a peak day, which is an increase of

approximately 4 times the average. The largest bilateral counterparty exposure reflected in

instructions settled by CLS was USD 64.9bn on average over the period. However, the

exposures increased 2.5 times over the average to USD 163.1bn on a peak day. As the RMB

increases internationally, and Chinese banks actively trade renminbi globally, to support the

real economy, the risk profile illustrated here could be applied to global Chinese bank.

The settlement values related to FX trades can vary substantially driven by response to

economic conditions and policy developments, market volatility or even bank holidays that

can lead to an equivalent of two days settlement processed on a single day. If these trades

were settled via a non-PvP system, FX market participants would need to accommodate this

level of risk (and volatility) through their counterparty pre-settlement and settlement limits.

Participants would be required to secure and manage counterparty settlement risk limits

with their global trading counterparties at these levels, an undoubted challenge as foreign

banks have reported to CLS that they could not settle such large volumes in the global FX

market without PvP.

22

CPSS, “Progress in reducing foreign exchange settlement risk”, May 2008. 23

CLS (Continuous Linked Settlement) is a global multilateral netting and PvP settlement service for FX trades. CLS provide FX settlement on behalf of some of the world’s largest financial institutions. 24

The data is based on the 17 currencies settled by CLS in Q2 2015, which are: Australian dollar, Canadian dollar, Danish krone, euro, Hong Kong dollar, Israeli shekel, Japanese yen, Korean won, Mexican peso, New Zealand dollar, Norwegian krone, Singapore dollar, South African rand, Swedish krona, Swiss franc, U.K. pound and U.S. dollar.

14

Whilst the mitigation of all risks is important, the paper examines more closely risks

associated with payments and settlement, in recognition that for many banks FX settlement

is the source of greatest risk exposure, which can lead to systemic risk in the global financial

system. The BCBS Global Supervisory Guidelines, options for settlement risk mitigation and

the importance of real time gross settlement (RTGS) payment systems connectivity in

developing risk mitigation solutions are discussed further in Section 3, 5 and 6 respectively.

2.2.3 Liquidity risk

Liquidity risk is defined in the BCBS Global Supervisory Guidelines as “the risk that a bank is

unable to make payments due to a shortage of liquidity arising from a counterparty (or

participant in a settlement system) not settling an obligation for full value when due”.21 In

the event that a bank (or any FX market participant) fails to meet its obligation in a timely

manner, it can lead to a knock-on impact to other counterparties which were rely on the

receipt of those funds in order to complete their own settlement obligations. These events

can lead to liquidity dislocations and disruptions to payment and settlement systems.

Liquidity pressures increase as currencies are traded more actively and participants are

required to secure larger sources of funds by managing their counterparty risk limits. As

market volatility and peaks in trading occur, pressures on these limits increase and market

participants look to risk mitigation and liquidity efficiency tools in order to fulfil their

obligations. As Chinese financial markets grow and cross border flows increase, the liquidity

pressures with respect to the renminbi as well as in the counter currencies to a renminbi FX

trade will grow. Regulatory guidelines on managing liquidity risk and options for risk

mitigation are discussed in Section 3 and 5 respectively.

2.2.4 Operational risk

The BCBS Global Supervisory Guidelines define operational risk is defined as “the risk of loss

resulting from inadequate or failed internal processes, people and systems, or from external

events. FX market operations, involving significant volumes of trades and payments

instructions across a vast array of market participants and jurisdiction operating in different

time-zones, gives rise to significant operational risk. Regulatory guidance on mitigation of

these risks is briefly outlined in Section 3.

2.2.5 Legal risk

Market participants are exposed to legal risk, which is defined in the BCBS Global

Supervisory Guidelines as a risk of “an unexpected application of a law or regulation, usually

resulting in a loss.”21 All financial market participants are exposed to this risk in all

jurisdictions in which the trade and settle transactions.

3 International regulatory standards

15

Monetary and financial stability is a precondition for sustained economic growth and

prosperity. While dynamic market economies necessarily involve some degree of volatility

and gradual structural changes, instability, in the form of, among other things, economic and

financial crises and unmanaged risk in financial markets, can increase uncertainty,

discourage investment and impede economic growth.

To understand the unique risk aspects relating to the FX market and the role of payment

systems in cross-border settlements, it is important to first examine international regulatory

and supervisory standards that inform market risk practices and assessments. FX is the

world’s largest financial market and the risks from settling FX transactions have long been a

concern of banking supervisors and central banks.25 Since the collapse of Bankhaus Herstatt

in 1974, banks and their supervisors have made consistent efforts to reduce and manage

these risks since they may create disproportionately larger concerns for market participants

during times of market stress.

Financial market infrastructures (FMIs) facilitate the clearing, settlement, and recording of

monetary and other financial transactions (for asset classes such as FX), such as payments,

securities and derivatives contracts. The term FMIs refers to systemically important payment

systems, central securities depositories (CSDs), securities settlement systems (SSSs), central

counterparties (CCPs), and trade repositories (TRs). Financial shocks could be passed from

one participant or FMI to others, extending the effects of such a disruption well beyond the

FMIs and their participants, and threatening the stability of domestic and international

financial markets and the broader economy. FMIs can contribute to and exacerbate systemic

crises if their risks are not adequately managed.

In recognition of the impact FX settlement and FMIs can have on stability in the global

financial system, several organizations have been founded to carry out research and policy

analysis on relevant issues and establish and promote financial policies, standards and

practices. This section introduces these organizations and key international standards

applicable to FX settlement and FMIs, highlighting principles and guidance regarding related

risks.

Bank for International Settlements Committee on Payments and Market 3.1

Infrastructures (CPMI)

As one of the oldest international financial organizations, the BIS’s mission is to serve central

banks in their pursuit of monetary and financial stability, to foster international cooperation

in those areas and to act as a bank for central banks. The BIS is represented by 60 member

central banks and monetary authorities representing countries from around the world and

its members include The People’s Bank of China (PBoC) and the Hong Kong Monetary

Authority (HKMA).

25

Trading in FX markets averaged USD5.1 trillion per day in April 2016, according to the 2016 BIS Triennial Central Bank Survey of FX and OTC derivatives markets.

16

The BIS hosts and supports the work of international committees engaged in standard

setting and the pursuit of financial stability, through its Basel process. There are six standing

committees located at the BIS which support central banks, including the Committee on

Payments and Market Infrastructures (CPMI) and the Basel Committee on Banking

Supervision (BCBS). The CPMI promotes the safety and efficiency of payment, clearing,

settlement, and related arrangements, and aims at strengthening regulation, policy, and

practices regarding those arrangements worldwide.26 The CPMI currently consists of 25

central banks, including the PBoC and HKMA.

Like the CPMI, the BCBS is a standing committee at the BIS. The BCBS’s mandate is to

strengthen the regulation, supervision and practices of banks worldwide with the purpose of

enhancing financial stability. The BCBS is comprised of 45 members consisting of central

banks and other authorities with formal responsibility for the supervision of banking

business; it includes the PBoC, the China Banking Regulatory Commission (CBRC) and the

HKMA.

CPSS (now CPMI) and IOSCO Principles for financial market 3.2

infrastructures (PFMI)

In April 2012, the CPMI (then known as the Committee on Payment and Settlement Systems

(CPSS)) and the Technical Committee of the International Organization of Securities

Commissions (IOSCO)27 published the standards report Principles for financial market

infrastructures (the PFMI) that updated international standards for financial market

infrastructures reflecting lessons learned from the 2008 financial crisis and the increasing

role FMIs play in the financial system and the broader economy.

The PFMI apply to all FMIs that are determined by national authorities to be systemically

important. Although statutory definitions of systemic importance may vary, in general a

payment system is systemically important if it has the potential to trigger or transmit

systemic disruptions.28

Most of the principles in the PFMI apply to all types of financial market infrastructures and in

all cases the set of principles applicable to an FMI are those that address the functions

performed by the particular entity. Additionally, the principles are applicable to FMIs

26

The CPMI was previously named the Committee on Payment and Settlement Systems, and the committee’s renaming became effective on September 1, 2014. 27

The International Organization of Securities Commissions (IOSCO) develops, implements and promotes adherence to internationally recognized standards for securities regulation. IOSCO’s ordinary members include the China Securities Regulatory Commission and the Hong Kong Securities and Futures Commission. In addition, the China Financial Futures Exchange, China Securities Depository and Clearing Corporation Limited, China Securities Investor Protection Fund Co., Ltd., Shanghai Stock Exchange, Shenzhen Stock Exchange, the Securities Association of China and Hong Kong Exchanges and Clearing Limited are affiliate members of IOSCO. 28

These payment systems include, among others, systems that are the sole payment system in a country or the principal system in terms of the aggregate value of payments, systems that mainly handle time-critical, high-value payments, and systems that settle payments used to effect settlement in other systemically important FMIs. With respect to other FMIs, there is a presumption that all CSDs, SSSs, CCPs and TRs are systemically important, at least in the jurisdiction where they are located, typically because of their critical roles in the markets they serve.

17

operated by central banks as well as those operated by the private sector. The PFMI

provides guidance for addressing risks and efficiency in FMIs and are designed to be applied

as a set and not on a stand-alone basis. FMIs should apply the PFMI on an ongoing basis in

the operation of their business.

CPMI and IOSCO members are committed to adopt the principles and responsibilities in the

PFMI in their jurisdictions through the adoption of legislation, regulations and policies.

Guidelines on managing risks in relation to settlement of FX transactions 3.3

Standards, guidelines and sound practices developed by the BCBS relate to, among others,

capital adequacy (the most widely known of which is the Basel III framework), cross-border

issues and market and operational risk. In February 2013, BCBS Global Supervisory

Guidelines offer guidance to supervisors and banks on mitigating those risks.

3.3.1 Replacement cost risk

The third guideline provides considerations for the mitigation of replacement cost risk,

including netting to reduce exposures through legally enforceable netting arrangements,

application of collateral with counterparties to cover the potential need to replace trades

that fail to settle, and through setting limits including market to market measurement of

exposures and stress testing models to ensure the risks and limits are accurately measured

and monitored. This guideline noted that “a bank should employ prudent risk mitigation

regimes to properly identify measure, monitor and control replacement cost risk for FX

transactions until settlement has been confirmed and reconciled”. In addition, guideline 7 of

the BCBS Global Supervisory Guidelines recommends that a bank should ensure that when

analysing capital needs, all FX settlement-related risks, including principal risk and

replacement cost risk should be considered and that sufficient capital is held against these

potential exposures, as appropriate.

3.3.2 Principal risk

To address principal risk, guideline 2 of the BCBS Global Supervisory Guidelines provides that

“a bank should use FMIs that provide payment-versus-payment (PvP) settlement to

eliminate principal risk when settling FX transactions”, and that where PvP settlement is not

practicable, banks should control and reduce the size and duration of its remaining principal

risk. PvP settlement is a settlement mechanism that ensures the final transfer of a payment

in one currency if, and only if, a final transfer of a payment in another currency occurs. While

PvP arrangements do not guarantee settlement, they do address the bank’s principal risk

exposure to its counterparty by returning the sold currency to the bank if the counterparty

fails to pay in the bought currency. PvP arrangements may be provided by a single payment

system or in the form of a link between two or more payment systems.

In the event PvP settlement is not practicable, the BCBS Global Supervisory Guidelines

recommends that banks should manage their remaining principal risk by setting binding

18

principal risk limits, measuring expected exposures appropriately and reducing them where

possible (potentially through obligation netting to reduce the size of principal risk) and

monitoring trade status to take prompt action when problems arise.

3.3.3 Liquidity Risk

Guideline 4 of the BSBC Global Supervisory Guidelines recommends that banks “should

properly identify measure, monitor and control its liquidity needs and risks in each currency

when settling FX transactions”. It also outlined key considerations concerning measurement

of liquidity needs, the requirement for a liquidity risk management framework that ensure

needs are appropriately represented, and the need to monitor and control liquidity demands

in each currency and that each bank should have sufficient liquidity in both normal and

stressed conditions, either in relation to activity in an FMI or through use of correspondent

banks.

3.3.4 Operational risk

Guideline 5 of the BSBC Global Supervisory Guidelines recommends that a bank “should

properly identify, assess, monitor and control its operational risks” and ensure that its

systems support risk management controls. The guideline also requires a bank’s operations

to have the capacity, scalability, and resiliency to handle FX volumes under normal and

stressed conditions. The guideline advises banks to maximize the use of straight-through

processing and to establish processes and procedures to allow it to confirm or positively

affirm FX trades as soon as practicable after execution to allow for effective monitoring and

control of risks from trade execution to settlement. In addition, banks should ensure that

their FX systems have sufficient capacity and scalability to handle increasing and high-stress

capacity needs, including large trading spikes in stress situations.

3.3.5 Legal risk

Legal risk relating to settlement of FX transactions is discussed in guideline 6 of the BCBS

Global Supervisory Guidelines. The guideline recommends that banks “ensure that

agreements and contracts are legally enforceable for each aspect of its activities in all

relevant jurisdictions”. Banks are advised to understand whether actions taken under

contracts would be subject to a stay beyond a de minimis period, voided or reversed in all

relevant jurisdictions, even when a counterparty defaults or becomes insolvent. Where a

bank’s agreements and contracts are not legally enforceable, the bank may face significant

unexpected or un-hedged FX obligations with potentially severe financial ramifications.

In addition, the guideline notes that banks should obtain legal advice addressing settlement

finality with respect to its settlement payments and deliveries, and that this legal advice

should take into consideration the impact of relevant bankruptcy and insolvency laws and

relevant resolution regimes.

19

The FX Global Code 3.4

The BIS established a Foreign Exchange Working Group (FXWG), with the aim to develop and

provide a set of global principles of good practice to promote the integrity and effective

functioning of the wholesale FX market. The FX Global Code of Conduct (FX Global Code)

was developed in partnership with central banks and in consultation with a diverse range of

market participants and providers around the world including corporates, asset managers,

trading platforms, ECNs and non-bank participants. SAFE and CFETS are members of the

FXWG and the Market Participants Group, respectively. A Chinese FX Committee (CFXC) was

established in June 2016, which operates under the PBoC and SAFE, to create the “China FX

Market Guidelines” [sic 中国外 市 准 ], which fully refers to the FX Global Code, suited

to domestic purposes.

The FX Global Code was published in May 2017, providing a set of global principles of good

practices for the wholesale FX market to promote fair, liquid, robust, open and appropriately

transparent market. The six leading principles covered by the FX Global Code including ethics,

governance, information sharing, execution, risk management and compliance and

confirmation and settlement processes. With respect to confirmation and settlement

processes, market participants are expected to put in place robust, efficient, transparent,

and risk-mitigating post-trade processes to promote the predictable, smooth, and timely

settlement of transactions in the FX market. Principle 50 of the FX Global Code encourages

the use of settlement services that reduce settlement risk, including PvP settlement

whenever practicable.

The FX Global Code does not impose legal or regulatory obligations on market participants,

nor does it substitute for regulation, but rather it is intended to serve as a supplement to

local laws, rules and regulations. However, the Markets Committee of the BIS will assess the

effectiveness of the FX Global Code three years after the launch, taking into account issues

such as breadth of adoption, effectiveness of adherence mechanisms, the extent to which

behaviour in the market has changed and the effect on the functioning of the FX market.29

The relevance to the Chinese financial markets is that global market participants are

expected to adhere and adopt the code, including joining public registers reporting adoption.

In addition, participating central banks are expected to limit their activity with market

participants to those institutions that have adopted the code. FX market practices and

Chinese financial institutions are expected to be increasingly impacted by global market

practitioners’ adherence to the principles of the code.

4 Impact of currency activity on risk profiles

The FX markets often reflect market activity and sentiment in the broader financial markets

and in particular, including significant market events such as political or central bank policy

developments. The following section illustrates the potential stresses and peaks that are

29

Foreign Exchange Working Group, “Report on adherence to the FX Global Code”, May 2017

20

experienced in FX trading activities, in particular addressing the concern outlined in the BCBS

Global Supervisory Guidelines that “substantial FX settlement-related risks remain due to

rapid growth in FX trading activities” and that risks may “create disproportionately larger

concerns during times of market stress”.

Trading and liquidity implications for FX market participants are examined, which are

relevant to China’s financial markets as global market activity and participation in the global

financial system grows.

Risk practices designed to monitor and limit counterparty risk 4.1

Guideline 1 (Governance) of the BCBS Global Supervisory Guidelines21 notes that banks

should have strong governance arrangements over their FX settlement-related risks,

including a comprehensive risk management process and active engagement by their boards.

Counterparty risk in FX trading operations is typically managed through pre-settlement risk

limits and settlement risk limits.30 The method of settlement has a direct impact on a trading

institution’s utilisation of its counterparty risk limits, including both pre-settlement and

settlement limits. International banks commonly utilize their counterparty pre-settlement

limits for FX forwards and swaps to manage the mark to market risk associated with future

volatility in market prices between the trade date (T) and the settlement date (V). Generally,

international market convention is not to apply pre-settlement risk limits to spot trades as

they are less likely to be subjected to significant price changes near settlement.

4.1.1 Counterparty limit management under PvP settlement

As long-dated FX trades mature and become due i.e. two days before the settlement date

(V-2), the pre-settlement allocation to the FX trade(s) against the counterparty is

automatically released i.e. forwards and swaps are essentially treated like spot trades. At

this stage, settlement risk limits come into effect. Some banks settling through a PvP

platform do not utilize settlement limits as PvP mitigates the risk of loss of principal. The

elimination of settlement risk and protection of principal provided by PvP settlement allows

trading institutions to apply their counterparty settlement limits to other products or

currencies that do not settle through PvP.

Table 4.1: PvP settlement – practices relating to utilisation of counterparty pre-settlement

and settlement limits at trade date (T) and near settlement date (V – 2).

T V - 2

Product (FX) Pre-settlement

limit allocation

Settlement limit

allocation

Pre-settlement

limit allocation

Settlement limit

allocation

Spot No/Yes31

No No/Yes31

No

Forwards, Swaps Yes No No No

30

Federal Reserve System, Trading and Capital Market Trading Manual, Section 2020.1: Counterparty Credit and Pre-settlement Risk, September 1999. 31

Some banks apply pre-settlement limits to their FX spot trades settled via PvP.

21

4.1.2 Counterparty limit management under Non-PvP settlement

For trading institutions that do not settle their FX trades through PvP, both pre-settlement

and settlement limits would be utilized in recognition of the risks associated with those

trades (see Table 4.2). Counterparty settlement limits, on a gross notional value basis, is

generally applied for all FX trades not settled through PvP.

Table 4.2: Non-PvP settlement –practices relating to utilization of counterparty pre-

settlement and settlement limits at trade date (T) and near settlement date (V – 2).

T V - 2

Product (FX) Pre-settlement

limit allocation

Settlement limit

allocation

Pre-settlement

limit allocation

Settlement limit

allocation

Spot Yes Yes Yes Yes

Forwards, Swaps Yes Yes Yes Yes

The elimination of settlement risk and the benefits from reduced counterparty credit limit

usage by using PvP settlement is preferred, in principle, over non-PvP settlement.

Risk management challenges during periods of market stress and 4.2volatility

High volumes of trading during periods of volatility can lead to insufficient trading limits

between counterparties, which in turn can limit trading and the FX market’s ability to

function appropriately. The accumulation of FX trades with counterparties can lead to

significant exposures to a single counterparty on a daily basis, which can exceed the entire

capital of the bank32 on a peak day.

4.2.1 A study of increased risk exposures on peak FX trading days

A study on FX trading banks’ counterparty risk management was previously performed to

quantify the range of exposures that trading institutions would need to accommodate with

their counterparties (on a bilateral basis) on a normal/average day and on a peak day. The

study was performed using aggregated, executed FX trade settlement data from CLS33 for

the 17 currencies settled in Q2 2015 at the counterparty level. CLS estimates that it settles

approximately 60% of eligible34 global FX turnover that is subject to settlement risk35 and

thus the data represents a significant proportion of the FX market and provides useful

insights to daily FX trading behaviours in the currencies it settles. Detailed descriptions of

32

CPSS, “Progress in reducing foreign exchange settlement risk”, May 2008. 33

CLS (Continuous Linked Settlement) is a global multilateral netting and PvP settlement service for FX trades. CLS provide FX settlement on behalf of some of the world’s largest financial institutions including over 60 of the largest global banks as Settlement Members (direct members) and over 23,000 active third parties (indirect members). 34

For the currencies that CLS settled in Q2 2015 (AUD, CAD, CHF, DKK, EUR, GBP, ILS, HKD, JPY, KRW, MXN, NOK, NZD, SEK, SGD, USD, ZAR ). The HUF was added as the 18

th currency in Q4 2015 and was not included in the

original analysis. 35

Excludes “On Us” activity, which does not involve transfer of funds across entities.

22

the methodology used to produce the analyses are provided in Appendix B.

The analyses of gross bilateral settlement amounts, which reflect exposures between banks,

provide evidence of significant increases in bilateral counterparty exposures on peak days

that can be several times greater than on a normal/average day (see Table 2.4). The data in

Table 2.4 shows that the average exposure between a bilateral counterparty on a peak day

in Q2 2015 was approximately 4 times the average exposure to a bilateral counterparty on

an average day. Similarly the largest exposure for a bilateral counterparty increased 2.5

times over the average on a peak day.

CLS data was further analysed to identify the potential pressures and stresses on

counterparty limits under normal and peak trading conditions at the currency level. Data

submitted by CLS’s members36 during Q2 2015 was analysed, which included the trades in

the 17 currencies that CLS settled and renminbi trades (which is not settled PvP in CLS)

between CLS members for the same period. The value of the offshore renminbi trades from

these institutions was equivalent to an average daily value of USD 164.7bn (counting both

sides).

The average gross bilateral settlement amounts, which reflect the exposures between banks,

for renminbi FX trades and also for the top five currencies settled in CLS during Q2 2015 is

summarised in Table 4.3. This also illustrates the magnitude of the difference between the

peak and average day for each of the six currencies analysed.

Table 4.3: Bilateral gross settlement exposures between CLS Members in Q2 2015 for the

offshore renminbi and CLS settled currencies (one side of the trade counted).

The above table highlights:

1. The scale and peaks of the amounts settled between trading institutions, across

markets and currencies.

2. The increased demands on counterparty risk limit utilisation, of particular

importance in periods of stress.

36

CLS provides a PvP settlement service to qualified and regulated financial institutions and in Q2 2015, 62 settlement members’ data contributed to the analysis, whilst a subset of 57 members who represent 90% of the total value settled in CLS, provided renminbi FX trade data executed with other CLS Members. 37

The CNH is not settled using PvP through CLS.

Currency (A) Average

exposure on an

average day in

USD bn

(B) Average

exposure on a

peak day in

USD bn

Peak to

Average

ratio

(B/A)

(C) Largest

exposure on an

average day in

USD bn

(D) Largest

exposure on a

peak day in

USD bn

Peak to

Average

ratio

(D/C)

CNH37

0.05 0.17 3.77 0.76 5.62 7.39

USD 0.71 2.33 3.30 28.61 73.00 3.18

EUR 0.32 1.48 4.65 14.71 32.82 3.52

JPY 0.18 0.78 4.37 6.84 18.51 2.71

GBP 0.17 0.88 5.15 4.11 14.47 2.23

CHF 0.10 0.45 4.46 3.86 12.27 2.55

23

Table 4.3 illustrates the magnitude of the differences between bilateral settlement

exposures for CLS Members on a peak and average day (i.e. the peak-average ratio) for (i)

the average exposure for bilateral counterparties and (ii) the largest single bilateral

counterparty exposure. As this average analysis may underestimate the range of ratios

experienced between counterparties, the bilateral exposures underpinning these results

were examined. The chart in Figure 4.1 is added to illustrate significant variations in the

peak to average ratios amongst the individual trading institutions within the data sample.

Using the same data, Figure 4.1 shows the proportion of bilateral counterparty trading

relationships across the reported peak-average ratios. The distribution of bilateral

counterparty trading relationships for a number of currencies, namely the renminbi and the

average of a basket made up of the top five currencies are plotted. The data underpinning

the graph shows that for the renminbi, the peak day bilateral counterparty exposure can

reach 20 times more than the average day exposure for the same bilateral counterparty i.e.

peak-average ratio of 20. Figure 4.1 shows the results for the USD, EUR, JPY, GBP and CHF as

a basket, which is indicative of the distribution profile for those currencies. The underlying

data shows that the highest peak-average ratio was 25 for USD, 33 for CHF, 35 for JPY, 38 for

GBP, and 47 for the EUR (the individual profiles for each currency in the basket are provided

in Appendix C).

The long tail suggests two things: (i) institutions’ trading profiles and exposures may be more

extreme than the average results in Table 4.3 and (ii) given the longer tail in the most

actively traded FX currencies, institutions are capable of accommodating a significant

variation in bilateral counterparty exposure on a peak day compared to their average FX

trading day.

Figure 4.1: Proportion of bilateral counterparty relationships of CLS Members,

against peak-average ratios (based on settlement amounts) for Q2, 2015.

24

As renminbi FX trading grows in absolute terms, the demands on counterparty risk limits will

be even higher and potentially beyond the ability of the banks and the markets to

accommodate and support demand for FX trades. This is particularly of significance for the

Chinese banks as the renminbi is the base currency of their business.

4.2.2 A study of counterparty risk limit impact during two different currency market events

The relatively large variation in settlement values among bilateral counterparties raises a

potential risk of insufficient counterparty credit limits during periods of high market

volatility, due to inadequate risk mitigation between counterparties, resulting in

dysfunctional markets and market pricing. To illustrate the impediment to FX trading as a

result of counterparty credit limit restrictions, an analysis of pricing data from the EBS

Market38 trading platform (a central limit order book) was performed to identify instances of

locked or crossed market activity. The definition of a locked market is where the best bid

price is equivalent to or higher than the best offer price. The data provided was for different

currency pairs traded on the platform under normal and abnormal market conditions.

The instance when a market for a currency pair becomes locked or crossed can occur in the

event that the counterparty showing the best bid price does not have sufficient bilateral

credit with their counterparty showing the best offer price to execute a trade (see Appendix

D). EBS Market incorporates a number of measures that prevent participants from

inadvertently publishing prices where a bid price exceeds the offer price in addition to

minimum institutional requirements, which includes monitoring to ensure institutions have

38

EBS Market is a global trading platform which supports the execution of FX trades with an estimated 70% share of the FX spot traded offshore renminbi (CNH) market (April 2016). The EBS Market trading platform is an anonymous central limit order book for Spot FX, NDFs (and precious metals). The USDCNH currency pair ranks in the top 3 currencies traded on EBS Market by daily value.

25

sufficient access to counterparty credit with other participants on the platform. Thus the

reason that a crossed or locked market occurs, according to EBS39, is due to insufficient

counterparty credit between participants.

The following analysis provides the opportunity to examine whether different settlement

methods have an impact on trading performance. The analysis focuses on contrasting

performance of trading in two currencies, the offshore renminbi (CNH) and the Swiss franc

(CHF) during significant market events. The largest trading institutions settle a majority of

their trades in CHF via PvP whilst very little settled PvP in the offshore renminbi market. The

analysis relates to periods of increased FX market volatility with increased bid/offer spreads

and market trading volumes. The periods in question relate to September 201540 for the

offshore renminbi market (USD/CNH) and in January 2015 when the Swiss franc was de-

pegged from the euro41 (EUR/USD).

On the January 15, 2015, the Swiss National Bank unexpectedly discontinued the peg of the

Swiss franc (CHF) against the euro (EUR).41 The unexpected move increased market volatility

and trading activity, which resulted in a depreciation of the EUR against the CHF of

approximately 27% initially and 19% by close of trading. As an indication of the volatility and

increased trading in the EUR/CHF market, CLS recorded a substantial increase both in value

and volume. There was a 20% daily increase in EUR/CHF trade values submitted for

settlement relative to the monthly average value over January 2015. Notably the proportion

of EUR/CHF spot and forward trades in CLS increased by approximately 3 times and 5 times

respectively, compared to the average EUR/CHF settlement values for January 2015.

On EBS Market (the trading platform), the EUR/CHF market spent only 196 seconds or just

over 0.2% of the day with locked/crossed markets (see Figure 4.2). For comparison, other

related currency pairs are also provided in Figure 4.2 showing the relative impact on those

FX currency pairs. In contrast to the EUR/CHF on September 10, 2015 the USD/CNH market

spent 7928 seconds (approximately 2 hours and 12 minutes) or 9.2% of the trading day with

locked/crossed markets (see Figure 4.3) when the CNH appreciated against the USD by

approximately 1.2% as a result of perceived measures to discourage speculation on the CNH.

39

While it is generally recognized that system lags can lead to locked markets, the infrastructure setup at EBS is such that only a lack of counterparty credit can lead to a locked or crossed market. 40

Reuters, China’s Yuan Jumps Offshore in Suspected Intervention, September 2015. 41

Swiss National Bank press release, Swiss National Bank discontinues minimum exchange rate and lowers interest rate to -0.75%, January 2015.

26

Figure 4.2: The proportion of time that markets were locked and crossed reported at daily

intervals for January 2015. [Source: EBS Markets]

Figure 4.3: The proportion of time that markets were locked and crossed reported at daily

intervals for September 2015. [Source: EBS Markets]

Despite the relatively small change in price for the USD/CNH (1.2%) compared to the

EUR/CHF (19.0%) the USD/CNH was more susceptible to crossed markets (9.2% compared to

0.2% for the EUR/CHF), which would prevent trading institutions from fulfilling their FX

orders to clients and carrying out day-to-day USD/CNH market transactions.

4.2.3 A study of Brexit events and impact on volatility

The global nature of cross-border transactions, which is facilitated by the FX market, directly

links domestic institutions and the global markets in which they participate. Foreign

macroeconomic and political events, such as the recent UK referendum on the European

Union (EU) membership (held on June 23, 2016) illustrate how those events can lead to

27

volatility and significant shifts in risk profiles of market participants. An analysis of

aggregated, executed FX trade data from CLS for the most actively traded currencies was

conducted in order to ascertain consequences for trading values surrounding the Brexit

events.

The daily settlement value for GBP/USD spot FX for the period before and after the British

referendum is displayed in Figure 4.4. The chart shows notable spikes in daily settlement

values, which coincide with significant Brexit related events or announcements (a

description of the events labelled in Figure 4.4 is provided in Appendix A).

Figure 4.4: Impact of Brexit-related events on daily GBP/USD FX spot values in CLS.

On the announcement of the UK referendum results on June 24, 2016, daily settlement

value for GBP/USD spot FX was USD 187bn, which is almost 3 times higher than the previous

day. At the intraday level, the increase is much higher. Figure 4.5 shows the hourly spot FX

trading value for GBP/USD submitted to CLS on June 24, 2016.

28

Figure 4.5: Intraday GBP/USD FX spot values submitted to CLS.

In the lead up to the UK referendum, financial markets priced in a “Remain” victory and

GBP/USD rose in the last days preceding the referendum. The YouGov “pseudo-exit” poll

indicated that “Remain” was favoured by 52% vs. “Leave” at 48%. As a result, GBP/USD

continued to rise to a high of 1.5018 at 22:00. With live results published in the early hours

(UK time) on June 24, 2016, ITV (a British national broadcaster) forecasted a 75% chance of a

“Leave” victory. This was an unexpected result for the market and volumes peaked at 03:00,

coinciding with the opening of financial markets in Asia. GBP/USD plummeted to a daily low

of 1.3229 by 05:00.

Using hourly interval submission values to CLS as a proxy for hourly FX trading activity42,

Figure 4.5 provides a number of useful insights.

The average 2016 hourly trading profile of submission values for GBP/USD spot FX,

shows that maximum value typically occurs at around 16:00, which coincides with

the time-zone overlap between London near-close of trading and New York open

trading. It also coincides with periods of greatest liquidity for this currency pair.43

Based on this 2016 average hourly trading profile of GBP/USD spot FX, GBP/USD is

not usually traded during Asia market hours (in significant amounts).

On June 24, 2016, GBP/USD spot FX values peaked in Asia market hours, at 03:00

and was almost 31 times higher compared to the average for the year (2016). To put

42

CLS members represent most of the largest FX market participants. Their processing of CLS submissions is generally fully automated and submissions to CLS are understood to be within minutes of actual trading taking place. 43

Bank for International Settlements, Markets Committee, “The Sterling ‘flash event’ of 7 October 2016”, January 2016.

29

this into context, by 03:00, 26% of the daily value for GBP/USD spot FX was

submitted to CLS on June 24, 2016 compared to 6% on an average day.

The intraday profiles for GBP/USD spot FX for the other peak days show intraday

peaks that exceeded the average daily profile by at least 4 times.

Liquidity pressures’ impact on risk limits 4.3

As well as needing counterparty credit limits to accommodate these large variations in

trading, the peaks in settlement can also lead to liquidity pressures for trading institutions,

particularly for those that settle gross, which can result in global and domestic payment

disruptions. While netting can help alleviate the liquidity required for settlement, delayed or

failed settlement can expose the receiving bank to liquidity pressures, because funds from

unsettled trades may have been intended to fund other transactions and obligations. The

uncertainty in receiving funds could lead to liquidity risk and may require a bank to

potentially raise funds at short notice to fulfil their obligations, which would potentially incur

additional costs.

The potential liquidity reduction required for settlement that can be achieved through a

central multilateral netting system, as discussed further in this Section 4, which

demonstrates significant reductions achieved by netting, in the number of payments and the

overall value of payments, meaning that trading institutions typically need to fund only a

fraction of the gross value to settle their FX trades. Statistical data from CLS has shown that

multilateral netting can reduce total funding required by approximately 95% of the gross

value44.

These efficiencies relieve stress on counterparty risk limits and the payment mechanism of

PvP, which protects a trading institution’s principal from loss; both of which, contribute to

more robust financial markets.

5 Options for FX settlement risk mitigation

Considering the value of FX transactions that settle globally is approximately USD 5 trillion

per day25 and that trading is concentrated in a few geographic locations and among the

largest financial institutions (generally banks), the scale of the potential losses from

settlement risk becomes clear. Should one large institution collapse, the resulting losses

may precipitate other losses in other institutions, as well as potentially cause significant

liquidity shortfalls that may lead to a substantive dislocation in the global financial markets

and financial system.

Trading institutions typically develop their own global risk frameworks using a combination

of “industry best practices” based on global regulatory guidance and risk controls developed

44

See slide 14 at https://www.newyorkfed.org/medialibrary/media/banking/internatonal/14-CLS-20-Kos-Puth.pdf

30

internally and specific to their operations. These risk management frameworks should at

least satisfy the guidelines adopted by the local regulator45 in the jurisdiction in which the

trading institution operates. The following approaches are recommended by the BCBS

Supervisory guidance for managing risks associated with the settlement of FX transaction

(February 2013) and more recently by the FX Global Code, which was released in May 2017.

The use of CCPs is encouraged where they reduce risk in the broader financial system for

certain OTC derivatives.46 It should also be noted, however, that settlement risk also applies

to cleared FX transactions and the application of risk mitigation regarding potential loss of

principal is also recommended for CCP’s and other FMI’s. A number of international CCP’s

are in collaboration to apply PvP to the settlement of FX transactions post clearing.

Non-payment versus payment settlement and the use of collateral and 5.1netting

In financial markets, counterparties may post collateral of eligible high-quality securities or

cash with each other to reduce their bilateral risk exposure. Whilst a commonly accepted

practice, posting collateral may be expensive and operationally challenging.

Where settlement is non-payment versus payment, banks can reduce their bilateral

exposures by payment netting – i.e. aggregating two or more of their payment obligations

with their counterparty to reach a “net” payment value that reduces the overall transfer of

funds required for settlement. While the BCBS Global Supervisory Guidelines recommends

the use of payment netting to reduce the size of a trading institution’s principle risk

exposures, in the absence of PvP settlement, payment netting still leaves residual settlement

risk with respect to the netted value.

To illustrate the benefits of payment netting, we introduce the concept using the following

example with four banks having to settle with each other. The example assumes gross value

of trading obligations of CNY 350m between four counterparties requiring 12 payments

where settlement is on a gross basis (see Figure 5.1).

45

The BCBS global supervisory guidelines was developed by a joint CPSS-BCBS working group that included representatives from central banks from Australia, Belgium, Canada, France, Germany, Hong Kong SAR, Italy, Japan, Korea, Netherlands, Russia, Saudi Arabia, Singapore, Spain, Switzerland, United Kingdom, and the United States, as well as the European Central Bank (ECB). 46

ISDA-AFME-NSA-ASSOSIM, “Comment on EC proposal for a Regulation on OTC derivatives, CCPs and trade repositories”, October 2010 at https://www.afme.eu/globalassets/downloads/briefing-notes/AFME-PTD-BN-Joint-Comment-Paper-on-EC-Proposal-for-Regulation-on-OTC-derivatives-CCPs-and-trade-repositories.pdf

31

Figure 5.1: Example of CNY payment flows between banks.

(a) gross settlement (b) bilateral net settlement

(c) multilateral net settlement

Figure 5.1 shows three different models of settlement: payment flows between

counterparties when settled on a gross funded basis (see Figure 5.1a), bilateral payment

flows once obligations are netted between each bilateral relationship to provide a single net

outgoing or incoming payment (see Figure 5.1b) and finally, with multilateral payment

netting, where the original outgoing and incoming payments for each bank against all its

counterparties are aggregated to provide a single net obligation being either an outgoing or

incoming payment. The example illustrates the benefits of netting, where bilateral netting

reduces funding for settlement to CNY 90m (74% netting efficiency) and six payments. Figure

5.1c illustrates the power of multilateral netting where only CNY 55m of funds are required

to enable settlement (84% netting efficiency) through just two payments. Netting

efficiencies will vary depending on size of the market, numbers of participants in the netting

service.

Bilateral payment netting requires agreement between just two counterparties. For market

participants to effectively net multilaterally, a standard service or intermediary with

standardized operating procedures for all participants is necessary. Such an arrangement

would require a standardized legal and operational framework for this purpose to create a

common basis of operation for all participants and ensure the payment netting is recognised

in each legal jurisdiction and that transactions, once settled, cannot be unwound. However,

10

Bank A

Bank B

Bank C

Bank D

35 30 40

20

30

20

30

40

60

25

10

Bank A

Bank B

Bank C

Bank D

25 10

10

10

20

15

Bank A

Bank B

Bank C

Bank D

15

40

32

once implemented, it is far more efficient than counterparty-to-counterparty bilateral

payment netting.

Standardized and enforceable legal agreements 5.2

If any form of netting solution is adopted it should be accompanied by a sound legal

framework. In the case of bilateral netting, market participants are called upon to establish

netting agreements with each legal entity and counterparty.

The BCBS Global Supervisory Guidelines advises banks to ensure that their agreements and

contracts with respect to their FX transactions, including netting provisions, are legally

enforceable in all relevant jurisdictions. Banks may face increased principal risk, replacement

cost risk and liquidity risk relating to counterparty failure if the counterparty’s contractual FX

obligations are unenforceable because, among other things, the applicable contractual

terms are impermissible or conflict with applicable law or regulatory policies or applicable

bankruptcy or insolvency laws limit or alter contractual remedies. Given this potential

impact on a bank’s risk profile and the risk that a bank may be forced to pay gross principal

or gross marked-to-market losses to a counterparty following a default or an insolvency, in

jurisdictions where bilateral payment netting may not be legally enforceable, the guidelines

recommend that banks ensure that they have compensating risk management controls in

place, such as reducing FX activities in those jurisdictions, imposing counterparty limits and

settling transactions on a gross basis.

The benefit of netting (bilateral or multilateral) is a reduction in the credit risk, liquidity risk

and the values exposed to settlement risk. However, netting only offers partial risk

mitigation, as there still remains the underlying settlement risk to the residual netted value.

Payment-versus-payment settlement 5.3

Payment-versus-payment is effected through a settlement mechanism that ensures the

transfer of both payment currencies (or payment legs) in an FX transaction is instantaneous

and, carried out when and only when, full funding from both parties is provided. The

transfer of payment will not take place when any party fails to provide its funds. If one party

fails to fund its side of a transaction in full, the original principal amount of the counterparty

is returned. Hence, there is no risk to the principal amount; however the loss the

counterparty remains exposed to is the replacement cost risk, being the additional cost

incurred to secure the required foreign currency to meets it obligations. This risk is

determined by the performance of the exchange rates and as such can be hedged using

standard risk management tools. It is commonly accepted that this replacement cost is a

fraction of the potential loss from settlement risk.

PvP settlement through the linking of different RTGS systems is the accepted best practice to

mitigating FX settlement related risk. This approach effectively eliminates the settlement risk

caused by the time lag between the two legs (payment leg and receiving leg) and requires an

intermediary entity that works with existing domestic RTGS systems to effect the

33

simultaneous payment and settlement with finality (supported by the rules of the system

and legal framework in the relevant jurisdictions).

5.3.1 Central bank funds versus commercial bank funds

It is worth noting that although PvP settlement mitigates FX principal risk, it does not

eliminate replacement cost risk or liquidity risk. The BCBS Global Supervisory Guidelines

advise banks to identify, measure, monitor and control those risks for FX transactions until

settlement has been confirmed and reconciled, including consideration for the credit and

liquidity risks associated with FMIs used to settle those obligations.

FMIs can use central bank money or commercial bank money (or a combination of both) to

conduct money settlements. However the use of commercial bank money to settle payment

obligations can create additional credit and liquidity risks for the FMI and its participants. A

commercial bank that conducts money settlement will have its own trades and exposures to

other commercial banks, which puts it at greater risk to default from its counterparties and

other market events. Should the commercial bank conducting settlement suffer from a

credit downgrade or other negative market sentiment, other banks may hold back payments

due to the uncertainty about its financial health, which could lead to a loss of confidence in

the payment system.

Principle 9 of the PFMI provides that systemically important payment systems should

conduct their cash settlements in central bank funds, where practicable and available, to

avoid credit and liquidity risks. With the use of central bank funds, a payment obligation is

discharged by providing the FMI or its participants with a direct claim on the central bank.

Central banks have the lowest credit risk and are the source of liquidity with regard to their

currency of issue. For and FMI, use of central bank funds to conduct cash settlements offers

a stable solution for the mitigation of FX settlement risk.

Binding constraints in RMB FX market 5.4

In 2015, CLS in association with four Chinese banks and nine non-Chinese banks, active in the

global FX market convened a bank forum (the Forum) to consider offshore developments of

the renminbi and FX risk management practices through bilateral discussions and surveys.

The Forum raised concerns and identified issues impacting the future global growth of the

RMB due to their binding constraints in FX trading.

The banks in the highlighted that renminbi FX trading in the offshore market is subject to

significant operational oversight, monitoring and intervention, which are less efficient than

models used for other comparably traded currencies that are settled on a PvP basis. The

banks that participated in the Forum reported the following challenges and constraints.

• When trades are settled through either a designated offshore clearing bank or the

RMB Clearing House Automated Transfer System (CHATS) on a gross basis, these

payments require intervention and enhanced monitoring by banks to ensure

34

completion of settlement due to (a) the absence of netting, creating high liquidity

demands and (b) the need to manage the release of payments and/or pursue funds

on a manual basis for bilaterally netted trades.

• Some Forum participants report having accounts with multiple offshore clearing

banks in order to address business needs or serve clients across geographies, and

therefore a separate process workflow in place with each offshore clearing bank.47

These workflows vary according to local regulatory requirements, and the systems of

the appointed offshore clearing bank, which adds cost and risk associated with

liquidity management and constrains scalability.

• Further operational challenges apply, such as issues with time-zone mismatches and

cut-off time differences. This means that participants in that market may need to

prefund an entire day’s trades, a procedure that carries opportunity cost. There are

also different cut-off times for China National Advanced Payment System (“CNAPS”)

and the RMB CHATS, and those set by offshore clearing banks, causing, in some

cases, the need to prioritize certain payment over others, resulting in timing

discrepancies and the need to pursue other counterparties in the funding chain for

liquidity.

• Presently there are different standards for validation and processing, as well as

different levels of communication across offshore clearing banks and jurisdictions,

introducing inefficiencies into the offshore renminbi market. This presents issues

when financial institutions on-board new counterparties or service clients across

different jurisdictions. Forum participants enjoy more standardized settlement

processes for the majority of their FX in comparable traded currencies, and global

market practice and preference of market participants include consolidated

settlement through a standard architecture that addresses time-zone issues,

mitigating operational risk. Such practices would save time and money for financial

institutions in terms of overhead, funding, overdraft charges, interest expenses, and

other expenses, and significantly reduce the amount of post-settlement work

related to failed payments. Participants in the Forum were concerned that a lack of

standardization, as well as geographic fragmentation of FX settlement, increases

costs, reputational risk and the potential for error, and could reduce scalability going

forward. Moreover, lack of standardization may increase as new technologies

emerge, new regions enter the market, and, more institutions trade renminbi

offshore.

The above-described concerns are mitigated to some extent, but the mitigants are costly

and operationally inefficient. For example, some of these issues are mitigated by overdraft

facilitates. However, certain institutions have noted that available overdraft facilities are

often much smaller than the payments being exchanged. At times, institutions are also

forced to access the repo market and undertake the costs and risks associated with that

47

The participants in the Forum recognize that there may be alternative means to obtain liquidity.

35

activity in order to obtain renminbi funds to meet daily needs, and some have reported that

the intraday repo lines for their offshore renminbi trading are often insufficient (less than

1%) for their needs. These points demonstrate the impact of non-netted and non-PvP

infrastructure on counterparty limits, which add pressures to funding activities.

5.4.1 Constraints associated with bilateral netting

Another potential way to mitigate funding constraints related to offshore renminbi is

bilateral payment netting arrangements with counterparties. The net amounts are likely to

be smaller than the original gross amounts, reducing principal and liquidity risks. However,

bilateral netting is considered by the Forum to be only a limited solution because:

• Sound practice requires market participants to establish bilateral netting

agreements with their counterparties. This requires a well-founded legal basis for

the enforcement of such agreements in all relevant jurisdictions, and banks

conducting business in multiple jurisdictions should identify, measure, monitor and

control for risks arising from conflicts of laws across jurisdictions.

• Trade settlement is generally a straight through process (STP). However, a trade

that is settled bilaterally requires manual intervention, meaning that the back office

would need to confirm a bilateral netting agreement (assuming one existed)

between the institution and counterparty, confirm the trades to be netted and the

netted value with the counterparty, seek internal credit approvals to settle the trade

and finally monitor the exchange. Each of these steps increases operational burden

and risk.

• The majority of institutions are not in the practice of using bilateral netting for

interbank trades, and so new internal practices and expertise would need to be

introduced on an institution-by-institution basis.

• Financial institutions are still exposed to principal risk on bilaterally netted amounts

in the event one side pays and the other defaults. The residual exposures may still

be high as bilateral netting efficiencies vary.

• Bilateral netting may reduce the number of payments that need to be made

between two counterparties, but if a large enough group of financial institutions can

engage in multilateral netting (i.e., the practice of combining all trades between

multiple counterparties and calculating a single net payment in each currency), the

result is that even fewer payments and less funding is required. Therefore, instead

of spending resources to implement adhoc bilateral netting, market participants

prefer to focus on the more impactful solution that is multilateral netting.

As a result of the funding constraints described above and the limitations of available

mitigants, the Forum highlighted concerns that existing arrangements may, in the near

future, cause challenges as the renminbi market continues to grow. The Forum proposed

36

that funding requirements for FX settlement can be compressed and pressures can be

reduced by payment system infrastructure that includes multilateral netting for the offshore

renminbi and its counter currencies.

6 Settlement risk mitigation through RTGS connectivity

One jurisdiction alone cannot mitigate cross-border settlement risk for the global FX market,

due to the very nature of settlement and funding needing to take place in two different

jurisdictions, funded by two different currencies through different RTGS systems. Effective

risk mitigation requires global collaboration through a multilateral payment infrastructure

that provides connectivity among RTGS systems. PvP is typically coordinated through an

intermediary infrastructure, such as the HKMA CHATS system or CLS.

As most of the FX trading may be transacted in jurisdictions other than a market

participant’s home country, as is the case with the renminbi where at least 80% of trading of

renminbi is offshore, risk mitigation provided by domestic systems will only address the risk

that prevails in the domestic market. The salient differences between a domestic and cross-

border payment process are introduced to highlight the primary risk considerations of

international payments, which arise from differences in operational and payment

infrastructures, operational inefficiencies between participating institutions and other

factors such as differences in time zones and legal frameworks. In order to articulate the

unique risks with respect to cross-border FX payments presented earlier in the paper, a

description of a typical domestic payment process is provided.

Domestic payments 6.1

A one-way payment made between two financial institutions such as a domestic interbank

transfer is often settled between the financial institutions using accounts held at their

central bank through a RTGS system.

An RTGS system is a payment system, which enables banks and other financial institutions to

make domestic payments between each other. Most advanced economies with mature

financial markets have RTGS systems. For example, the U.S. has Fedwire and the Euro area

has the Trans-European Automated Real-time Gross settlement Express Transfer system

(TARGET2); in the case of China there is the China National Advanced Payments System

(CNAPS) and specifically for cross-border renminbi payments there is the Cross-Border

Interbank Payment System (CIPS). These systems are a vital component of a country’s

payment system infrastructure, contribute to the economic stability and growth of a country,

and are typically operated by the central bank.48 RTGS systems do not physically exchange

money; they continuously adjust account balances of the financial institutions that

participate in the RTGS system (for their own account or on behalf of their clients) across the

books of the central bank i.e. in funds held at the central bank. While it is possible, in

48

Swift, “Reducing risk and increasing resilience in RTGS payment systems”, 2014.

37

principle, for an RTGS system to settle payments across the accounts of a commercial bank,

this would introduce credit risk.49

RTGS systems can be categorised into large value funds transfer systems, typically used by

financial institutions for large value and time critical payments, and high volume funds

transfer systems, typically used by retail entities (for relatively low values and less time

critical payments).

An illustration of a simple one-way payment is provided in Figure 6.1. If account holder A

and account holder B, with accounts at different banks (Bank A and Bank B, respectively)

want to exchange payments, Bank A can use the RTGS system to transfer funds to Bank B.

Bank A sends a payment instruction on behalf of its customer to Bank B via the central bank

controlled RTGS system. The RTGS system debits Bank A’s account, at the central bank for

the instructed amount, while simultaneously crediting Bank B’s account (also at the central

bank). Bank A and Bank B would subsequently make corresponding adjustments to their

customers’ accounts upon receipt of these payment instructions. In this set-up, credit risk is

mitigated, if settlement is final and irrevocable50, because cash is transferred between banks

in real time in central bank funds.

Figure 6.1: Schematic showing the flow of funds for a one-way domestic payment through

a central bank’s RTGS system. (solid line = fund flow, dotted line = instruction)

Although the rules and operating procedures of an RTGS system and the legal environment

for each country may vary on technical matters relating to finality, in most cases settlement

is final and irrevocable once the payment is recorded on the accounts of each commercial

bank at the central bank. Thus, as supported by the legal framework, the payment between

the two financial institutions in this example (Bank A and Bank B) is settled with finality and

irrevocably through transactions in the RTGS system. In this example, because accounts are

debited and credited simultaneously, in a one-way payment there is no specific credit or

settlement risk to either commercial bank. But, when there are two, interlinked payments

across two unrelated national payment systems, there may be a material delay between the

49

Bank for International Settlements, Real-Time Gross Settlement Systems, Basel March 1997 50

In some countries, RTGS credited funds may be irrevocable under the system’s rules but under the general rules of the country an entity may have the right to make a claim, which creates legal uncertainty and undermines confidence in payment finality.

Central bank

Commercial bank A account

Commercial bank B account

Commercial bank A Commercial bank B

38

two payments creating the potential for credit or settlement risk should one of the

participants not be able to make the payment as requested.

Risk considerations for cross-border payments 6.2

Typically FX related transactions are cross-border two-way payments.51 These transactions

are carried out across different RTGS systems and subject to potential differences in time

zones, RTGS system messaging and operational standards, and legal frameworks, which are

outside the control of the domestic central bank and financial institutions. These differences

can present uncertainties, which are a risk to settlement. In the extreme case, such as credit

events, financial institutions are subject to potential loss of the principal value.

To illustrate the cross-border payments process, an FX transaction between Bank A and Bank

B is used as an example, where Bank A buys Hong Kong dollars (HKD) in return for U.S.

dollars (USD).

Figure 6.2 shows a typical set-up for cross-border FX payments. Bank A and Bank B agree on

an FX trade on date T and agree to settle (exchange payments) on T+2 i.e. a spot trade52. On

T+2, Bank B would initiate payment of Hong Kong dollars to Bank A’s correspondent bank (or

Bank A’s branch) in Hong Kong to fulfil its payment obligation. A confirmation of payment

receipt would then be sent by Bank A’s correspondent to Bank A in the United States. Due to

time zone differences, Bank A can only send its U.S. dollar obligation to Bank B’s

correspondent (or Bank B’s branch) late in the day of Bank B (or after business hours). Once

the transfer is complete, Bank B’s correspondent will send a confirmation of payment

receipt, which might not be received by Bank B until the next business day i.e. T+3. Until the

final payment is made, Bank B has an exposure to its counterparty.

Figure 6.2: Schematic showing the flow of funds for two-way cross-border payments in FX

settlement. (USD payment: dashed line, HKD payment: solid line, notification: dotted line)

51

Where each counterparty to the FX trade is obligated to deliver value in a currency. 52

Typically, spot FX transactions settle on the second business day after the trade takes place. There are trades that settle the same day (same day trades) and trades that settle some date in the future (forwards).

39

6.2.1 Differences in time zones

Payments for FX involve two currencies that settle across two different RTGS systems that

might be located in two different countries and potentially different time zones. For example

if an onshore Chinese bank sells CNY and buys USD from a U.S. Bank for delivery offshore, it

must transfer the CNY via the Chinese payment system (CNAPS) to the U.S. bank’s

correspondent bank in China. Separately the U.S. bank must transfer the USD to the Chinese

bank’s correspondent bank in the U.S., which would take place once the U.S. payment

system, Fedwire, is open (see Figure 6.3).

Figure 6.3: CNAPS and Fedwire operating times.53 All times displayed using the Beijing time

zone, times in brackets reflect the U.S. winter time.

Due to the time difference between Beijing and New York, which is 12 hours (or 13 hours in

the winter), when the Chinese bank fulfils its CNY obligation on value date (V), it does not

know with certainty that the U.S. bank will make (or when it will make) the corresponding

payment in USD. The time difference between the Chinese bank making its payment and

receiving payment exposes it to settlement risk to the full value of the transaction. Given

that the size of typical FX transactions are in the equivalent of tens of millions of USD and

many large financial institutions make several thousand trades on a daily basis, the

aggregate settlement risk exposures can easily dwarf both the capital and the liquidity of a

bank.54 A way to reduce that risk is to make simultaneous payments, which requires that

both systems are concurrently open and both payments can be executed simultaneously.

6.2.2 Differences in RTGS systems, operational and messaging standards

Modern RTGS payment systems are highly automated, use robust architecture, are

technologically and operationally resilient, rarely require manual intervention and rely on

highly standardized payment instructions. Typically banks, or other financial institutions,

facilitate payment instructions/messages between each other by adopting internationally

accepted messaging standards, which enable automation and straight through processing.

Automation reduces the need for manual intervention, reducing message errors, increasing

53

Source from the Federal Reserve Bank of New York https://www.frbservices.org/operations/fedwire/fedwire_hours.html 54

Bank for International Settlements, CPSS, “Settlement Risk in Foreign Exchange Transactions”, March 1996, page 2

Settlement risk due to time zone differences

Day 1 – 08:30 CNAPS HVPS starts

Day 1 – 17:00 CNAPS HVPS closes

Day 2 – 08:30 CNAPS HVPS starts

Day 2 – 17:00 CNAPS HVPS closes

Day 1 – 09:00 (10:00) Fedwire starts

Day 1 – 06:30 (07:30) Fedwire closes

Day 2 – 09:00 (10:00) Fedwire starts

40

efficiency and reducing costs (e.g. costs of developing bespoke messaging formats and

systems).

However, different financial institutions and payment infrastructures may operate under

distinctly different operational and technological requirements55, which in turn could

impede the efficient and timely processing of standardized payment instructions, thereby

lengthening the time the payment reaches the intended bank. For instance, the payment

instructions for the same FX trade may be formatted differently to meet the individual RTGS

system’s specific criteria and contain superfluous information that is only relevant to one

side of the payment flow. These complications may be compounded if the operational

requirements of the various RTGS systems involved in the transaction differ. Each of these

differences has the potential for increasing operational complexity by potentially requiring

manual intervention when processing these cross-border payments.

The global financial industry has adopted a number of common messaging standards that

specifically serve different functions and asset classes. For the purposes of FX payment

instructions, SWIFT56 provides a set of standardized messages used by over 7,500 financial

institutions in 200 countries (either as SWIFT Message Type or XML ISO 20022 format). The

widely used global SWIFT standards significantly reduce these risks through standardized

payment instructions, uniform formatting, and global adaptability. RTGS systems are often

SWIFT based or at least SWIFT compatible, allowing for a high degree of standardization and

efficiency. Seventy-four of 125 global RTGS systems are SWIFT based, including the RTGS

systems of the Hong Kong Monetary Authority and other advanced economies.57 The rest

are SWIFT compatible and accept standardized SWIFT messages.

6.2.3 Differences in legal systems

The legal framework plays an important role in the enforceability of payments through an

RTGS system. The differences in the legal systems and how legal systems consider

transactions in an RTGS system can lead to uncertainty and risk in the settlement of

payments relating to FX trades.

RTGS systems are considered to be systemically important financial market infrastructures

and, following international standards, they should have a well-founded, clear, transparent,

and enforceable legal basis for their activities in their operating jurisdiction58. It is generally

understood that where settlement is made by the transfer of central bank funds, final

settlement occurs when the final (i.e. irrevocable and unconditional) transfer of value has

been recorded on the books of the central bank. However the rules and operating

procedures of an RTGS system and the relevant legal environment may offer differing

concepts of finality, creating uncertainty when considering two-way cross-border payments

55

Bank for International Settlements, Real-Time Gross Settlement Systems, Basel March 1997, page 1 56

Society for Worldwide Interbank Financial Telecommunications (SWIFT) is an industry-owned cooperative that provides a telecommunications network to allow financial and non-financial institutions to transfer financial transactions through a message. 57

See Swift, “Reducing risk and increasing resilience in RTGS payment systems”, 2014, page 6 58

See CPSS IOSCO “Principles for financial market infrastructures”, April 2002 at Section 3.0, page 21.

41

for FX trades. Lack of clarity or legal enforceability arising from these differences increases

the risk for domestic and non-domestic participants with respect to payment finality. In an

FX transaction where cross-border payments are carried out using two RTGS systems, FX

participants need to be legally assured that payments are not at risk of being unwound post

settlement.

7 Importance of FX settlement risk mitigation to China and the renminbi

China’s risk profile as it continues global financial integration 7.1

China’s has clearly stated its objective to, and made substantial progress toward, growing its

participation in the global financial system alongside the development of China’s importance

to the global economy. Ensuring global integration of China’s financial markets and financial

institutions is consistent with both China’s objectives, as well as that of global investors who

seek to develop increased trade, FDI and portfolio investment in China’s markets.

Whilst the primary focus is on development of the capital markets, it is important to

recognise the importance developing liquid and robust FX markets in order to achieve those

broader goals. Cross border activity in all asset classes requires the exchange of currencies.

Therefore to the extent foreign investors participate in the Chinese market; a well-

functioning FX market is a prerequisite. FX is the largest and most liquid market in the

world, generating turnover of approximately USD 5 trillion [CNY 34 trillion] every business

day.

This paper has highlighted the risks in the FX market, as summarized by global regulators

that China will face as it continues to integrate into the global financial system. The types

and scale of risk will grow: initiatives such as OBOR, Bond Connect and other progressive

developments will link China’s financial systems and institutions to the international markets

and financial institutions. CLS’s unique data provides some transparency and insights into

potential sources of risk and volatility in the global FX market that create risk management

pressures which Chinese financial institutions and markets will face, and CLS data has been

presented to highlight the impact of volatility on counterparty and liquidity risk limits.

References to recent global events have been used to demonstrate how these events can

manifest across the globe and negatively influence domestic markets and participants.

The impact of global investor perspectives and international practices 7.2

While China has established infrastructure to support wider adoption of the renminbi and to

attract investment capital, the perspectives of foreign investors should be considered in

order to help drive greater capital inflows into China and its integration into global financial

systems. Foreign direct investors (FDIs) are motivated to invest in emerging market countries

because of attractive risk adjusted returns. The investment through collaborations or joint

ventures, or investment through capital markets supports growth. A report by the Working

42

Group of the Capital Markets Consultative Group (CMCG) of the IMF highlighted the key

factors that consistently determine investment in a country:

Availability of efficient infrastructure, in particular roads, transportation,

telecommunications and financial services.

Transparent and enforceable legal framework and rule of law, which facilitate clarity

of contracts and obligations among economic agents.

FDIs seek profits based on expected risk adjusted returns, taking particular account

of economic and political risks. The report highlighted the importance of currency

risks, and carefully managing their currency risk through assorted hedging tools.

Development of local capital markets, with an emphasis on providing a diverse range

of financing and hedging sources is a precondition for supporting robust FDI flows.

Firms use hedging to protect against heightened uncertainty, with greater reliance

on local borrowing and the FX markets.

Investors will be more ready to increase their commitment to a given market as the depth of

capital markets grows. 59 That implies growth of money markets, capital markets as well as

equity markets. But in order to generate inflows, whether FDI or portfolio flows, a deep and

liquid FX market is a vital component as this provides the mechanism to make investments in

a safe and secure fashion. While capital controls are also a consideration for FDIs, the

financial payment infrastructure that supports multilateral cross-border transactions is a

vital component to providing investors with the confidence that FX transactions can be

executed with a stable and efficient global payment system that follows global best

practices.

Even before the financial crisis, national and global regulators recognized the systemic

importance financial market infrastructures play in the smooth functioning of financial

markets. Infrastructure supporting the FX market, the largest financial market in the world,

is of particular concern. Because of its interconnected nature, local disruptions can

propagate global events, as the disruptions caused by the global financial crisis and

Bankhaus Herstatt ’s collapse demonstrated. Hence, the regulatory standards in response to

the 2007/2008 global financial crisis, including the Basel III framework, sought to create a

globally more resilient, better capitalized, and more risk-aware financial system.

On a global basis, regulators increased capital requirements against the various risks banks

take, redefined the riskiness of various assets, and imposed new quantitative and qualitative

standards. For banks active in the FX markets, their capital requirements for FX transactions

and FX exposures increased. More risk sensitive capital requirements against counterparty

credit risk increased capital requirements on bilateral trading. It has motivated banks to

proactively assess, evaluate, and manage their bilateral trading and credit risk exposures

with each other. Reducing settlement risk is one of the ways to achieve this.

59

“Foreign direct investment in emerging market countries”, report of the Working Group of the Capital Markets Consultative Group of the IMF, September 2003.

43

The imposition of quantitative liquidity standards through the liquidity coverage ratio (LCR)

required financial institutions to reallocate their balance sheet into holding lower yielding

assets, effectively reducing the economic earnings capacity of financial institutions.

Multilateral netting offered by various providers and infrastructures indirectly reduces the

LCR requirements and reduces the capital burden.

Importance of infrastructure support to China’s financial markets and the 7.3renminbi

China has taken constructive steps to facilitate greater cross-border connectivity by creating

a payment system to support cross-border payments, namely CIPS, and a global network of

renminbi clearing banks. This renminbi-specific infrastructure facilitates cross-border

payments and its application of global standards in its development is a strong and positive

step in maturing the payments infrastructure in China. However, both the renminbi and the

counter-currency leg of a FX trade do not fully benefit from settlement risk mitigation as no

single jurisdiction can solve effectively for cross border settlement risk. This asymmetry has

significant negative impacts on counterparty credit and settlement risks limits, bilateral

trading limits and liquidity efficiencies.

A global PvP system with connectivity to domestic RTGS systems, that settles in central bank

funds (such as CLS’s settlement service), would allow trading institutions in the renminbi and

in particular, Chinese financial institutions to reduce their overall counterparty settlement

risk limits because their settlement risk is mitigated in accordance with accepted risk

management best practices and the highest global regulatory guidelines. Without such a

global intermediary to help address operational risk and legal risk, international banks may

set lower counterparty limits to their Chinese counterparts in order to reduce exposures in

case of default, and domestic markets may be more susceptible to market events and

instability, impacting the internationalisation of the renminbi. The CLS system is overseen by

a committee of all the participating central banks of the currencies settled in the system.

This provides transparency and a co-operative governance structure for the benefit all

participating central banks. The CLS system, a systemically important financial market

infrastructure, continually evaluates data, trends and its risk framework and works with the

eco-system to ensure that risks are understood and that the highest standards are applied in

order to manage and mitigate risks wherever possible.

The renminbi is the only currency included in the SDR that is not eligible for PvP settlement

through a global settlement system in central bank funds60, such as CLS. As the BIS’s

December 2016 Quarterly Review implies, not being able to settle renminbi payments

through PvP such as CLS may act as one of the practical constraints in terms of further and

broader international acceptance of the renminbi61. As noted in a study on risk mitigation in

the global FX markets, in particular for emerging market currencies where access to

60

PvP is available in the offshore renminbi market through RMB CHATS operated by the HKMA, however the counter currency leg settles in commercial bank funds and thus only provides a partial FX settlement risk mitigation 61

Moore, M., Schrimpf, A., and Sushko, V., “Downsized FX markets: causes and implications”, BIS Quarterly Review, December 2016, pages 35-51.

44

settlement risk mitigation is less prevalent, it is estimated that at least half the FX market

turnover is exposed to settlement risk.62 As such, a strong domestic financial market and an

established and tested infrastructure that supports safe and efficient cross-border payments

are critical for supporting growth and stability of renminbi internationalisation.63 A domestic

financial system, which would facilitate transactions with foreign institutions, should, from

an FX payment infrastructure perspective, be:

a) Supportive of providing an environment that reduces financial institutions and

investor concerns about operational and legal risks;64

b) Resilient to market shocks by mitigating risk in loss of principal;

c) Facilitate a liquid market that supports cross-border trade and investment, which is

underpinned by the FX market.

For the renminbi to assume a greater global role and influence, it must also become an

international medium of exchange where the participants in the market, among other

factors, have comfort and security in the settlement of renminbi transactions through

systems that comply with international practices and standards.

62

Kos, D. and Levich, R.M., “Settlement Risk in the Global FX Market: How Much Remains?”, October 2016 63

程 , “人民 离岸市 与人民 国 化 ——基于支付清算系 的 角”, 2016年 12月 64

International Monetary Fund Report of the Working Group of the Capital Markets Consultative Group “Foreign Direct Investment Emerging Market Countries”, September 2003

45

Appendix A: Daily foreign exchange activity following Brexit

The description of Brexit related events, which are believed to have had an impact on the FX market, below, was extracted from a CLS Analytics report.65

Figure A.1: Impact of Brexit-related events on daily GBP/USD FX spot values in CLS.

Referendum results on June 24, 2016: UK votes to leave the EU. The last polling before the

referendum showed a statistical tie. However, both financial and betting markets priced in a

“Remain” victory and GBP/USD rose in the last days preceding the referendum. The YouGov

“pseudo-exit” poll indicated that “Remain” was favoured by 52% vs. “Leave” at 48%. As a

result, GBP/USD continued to rise to a high of 1.5018 at 22:00. With results from different

areas being published in the early hours of June, 24 2016, betting odds moved in favour of a

Leave result and ITV (a British national broadcaster) forecasted a 75% chance of a “Leave”

victory. This was an unexpected result for the market and volumes peaked at 03:00.

GBP/USD plummeted to a daily low of 1.3229 by 05:00.

Sterling’s flash crash on October 7, 2016: In the span of several minutes in early Asia trading,

GBP/USD plunged from 1.2614 to 1.0932 (as recorded by executed trades submitted to CLS

for settlement) before retracing much of the move. According to a BIS report, the beginning

of this extreme decline in sterling was caused by significant demand to sell sterling to hedge

option positions and, to a lesser extent, stop-loss orders. The presence, outside the

currency’s core time zone, of staff less experienced in trading sterling, with lower risk limits

and risk appetite, and with less expertise in the suitability of particular algorithms for the

prevailing market conditions, appears to have further amplified the movement. It is hard to

qualify the flash crash as a Brexit-related event but it happened amid negative sentiment

65

CLS Analytics report, https://www.cls-group.com/MC/Documents/CLS%20data%20insights-%20FX%20activity%20Brexit%20June%202017.pdf

46

towards the pound, days after British Prime Minister Theresa May outlined for the first time

her vision for Brexit at the Conservative Party conference.

British Prime Minister calls snap election April 18, 2017: GBP/USD volumes peaked and

GBP/USD FX rate rose over 2% to a six month high after Prime Minister Theresa May

announced a snap election on June 8, 2016. Early polling showed that May’s Conservatives

enjoyed a material lead against the Labour Party, and a victory could deliver May a larger

majority and solidify the legitimacy of her mandate, given her status as an unelected leader.

47

Appendix B: Counterparty exposure calculations

The below analysis was undertaken to quantify the scale of FX settlement risk mitigation

between counterparties. An analysis of the trade settlement data from CLS for the 17

currencies settled in Q2 2015 was performed at the counterparty level to determine the:

Average exposure across all bilateral counterparties

o On an average day

o On a peak day

Maximum exposure across all bilateral counterparties.

o On an average day

o On a peak day

A description of CLS’s data is provided including the calculations used to determine

counterparty exposures between entities on a bilateral basis.

Description of CLS data

CLS is a global financial utility, which supports domestic infrastructure to provide FX PvP

settlement for over 60 of the largest global banks as Settlement Members (direct members)

and over 23,000 active third parties (indirect members). CLS estimates that it settles

approximately 60% of eligible66 global FX turnover that is subject to settlement risk.67 CLS’s

data represents a significant proportion of the FX market and provides useful insights to

daily FX trading behaviours. It can be used as a proxy of FX market trends at the product

level and currency level for the currencies it settles.

FX trade level information is captured and stored by CLS when members wish to submit

instructions to settle FX trades using PvP. Instructions submitted to CLS include the following

FX trade information68:

Party identification e.g. institution name, BIC code

Counterparty identification e.g. institution name, BIC code

Currency information e.g. buy and sell currencies

Trade value e.g. value of trade in the native currency value

Date e.g. the date the trade was agreed and the date of requested settlement (value

date)

66

For the currencies that CLS settled in Q2 2015 (AUD, CAD, CHF, DKK, EUR, GBP, ILS, HKD, JPY, KRW, MXN, NOK, NZD, SEK, SGD, USD, ZAR ). The HUF was added as the 18

th currency in Q4 2015 and was not included in the

original analysis. 67

Excludes “On Us” activity, which does not involve transfer of funds across entities. 68

Only a summary of the data is presented that was used for the purposes of the analysis in this report.

48

Calculation methodology

Trade level data was extracted for trades with settlement/value date in Q2 2015 and

subsequently aggregated by bilateral counterparty pair and by day to create a dataset for

analysis. The following equations were applied

𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝑒𝑥𝑝𝑜𝑠𝑢𝑟𝑒 𝑎𝑐𝑟𝑜𝑠𝑠 𝑎𝑙𝑙 𝑏𝑖𝑙𝑎𝑡𝑒𝑟𝑎𝑙 𝑐𝑜𝑢𝑛𝑡𝑒𝑟𝑝𝑎𝑟𝑡𝑖𝑒𝑠 𝑜𝑛 𝑎𝑛 𝑎𝑣𝑒𝑟𝑎𝑔𝑒 𝑑𝑎𝑦 =1

𝑖

1

𝑛∑ ∑ 𝑣𝑖𝑘

𝑛

𝑘=1𝑖

𝑙𝑎𝑟𝑔𝑒𝑠𝑡 𝑒𝑥𝑝𝑜𝑠𝑢𝑟𝑒 𝑎𝑐𝑟𝑜𝑠𝑠 𝑎𝑙𝑙 𝑏𝑖𝑙𝑎𝑡𝑒𝑟𝑎𝑙 𝑐𝑜𝑢𝑛𝑡𝑒𝑟𝑝𝑎𝑟𝑡𝑖𝑒𝑠𝑜𝑛 𝑎𝑛 𝑎𝑣𝑒𝑟𝑎𝑔𝑒 𝑑𝑎𝑦 = 𝑚𝑎𝑥 [1

𝑛∑ 𝑣𝑖𝑘

𝑛

𝑘=1

]

𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝑒𝑥𝑝𝑜𝑠𝑢𝑟𝑒 𝑎𝑐𝑟𝑜𝑠𝑠 𝑎𝑙𝑙 𝑏𝑖𝑙𝑎𝑡𝑒𝑟𝑎𝑙 𝑐𝑜𝑢𝑛𝑡𝑒𝑟𝑝𝑎𝑟𝑡𝑖𝑒𝑠 𝑜𝑛 𝑎 𝑝𝑒𝑎𝑘 𝑑𝑎𝑦 =1

𝑖∑ 𝑣𝑖𝑘

𝑖

𝑙𝑎𝑟𝑔𝑒𝑠𝑡 𝑒𝑥𝑝𝑜𝑠𝑢𝑟𝑒 𝑎𝑐𝑟𝑜𝑠𝑠 𝑎𝑙𝑙 𝑏𝑖𝑙𝑎𝑡𝑒𝑟𝑎𝑙 𝑐𝑜𝑢𝑛𝑡𝑒𝑟𝑝𝑎𝑟𝑡𝑖𝑒𝑠 𝑜𝑛 𝑎𝑛 𝑝𝑒𝑎𝑘 𝑑𝑎𝑦 = 𝑚𝑎𝑥 [∑ 𝑣𝑖𝑘

𝑛

𝑘=1

]

Where:

v = total settlement value (USD equivalent)

n = number of days

k = kth day

i = bilateral counterparty pair

A peak day in Q2 2015 corresponds to the day with the highest total settlement value (in

USD equivalent) in CLS i.e. April 8, 2015.

49

Appendix C: Peak-average ratios for different currencies

The following charts show the proportion of bilateral counterparty relationships against peak-average ratios for the renminbi compared with the top 5 currencies settled in CLS.

Figure C.1: Proportion of bilateral counterparty relationships against settlement value based peak-average ratios for different currencies in Q2, 2015.

(a)

(b)

(c)

50

(d)

(e)

51

Appendix D: Crossed market example

A simplified illustration of how a market becomes crossed is provided in Figure D.1 below.

Figure D.1: Example of bid and offer prices for USD/CNH by participants and their

counterparty credit availability:

(a) Normal market

Bid

(USD/CNH)

Offer

(USD/CNH)

Sufficient bi-lateral

credit with Participant #

Best available tradable

price 6.6658 6.6665 -

Participant 1 6.6658 6.6668 2, 3

Participant 2 6.6655 6.6665 1, 3

Participant 3 6.6657 6.6667 1, 2

(b) Crossed market

The table in Figure D.1 (a) illustrates a simple fictional case where all participants have

available counterparty limits with all other market participants. Only the best available

bid/offer price from the pool of participants is available69 to execute trades (in this case

Participant 1 for the best bid price and Participant 2 for the best offer price).

In the table Figure D.1 (b), Participant 2 and Participant 3 now no longer have sufficient bi-

lateral credit with each other, which could be the result of earlier trading activities between

the two participants exhausting their bi-lateral counterparty limits. Although Participant 2

and Participant 3 offer the best offer and bid prices respectively, the addition to the

fragmentation in the market as a result of not being able to trade with each other due to

insufficient counterparty limits, results in a crossed market, which also means that other

participants i.e. Participant 1 can no longer execute their trades. A locked market would be

one where the best bid and offer prices were equal.

69

Individual participant prices are not available on EBS Market, only the best bid/offer price is displayed and on an anonymous basis.

Bid

(USD/CNH)

Offer

(USD/CNH)

Sufficient bi-lateral

credit with Participant #

Best available tradable

price 6.6665 6.6660 -

Participant 1 6.6658 6.6668 2, 3

Participant 2 6.6655 6.6660 1

Participant 3 6.6665 6.6675 1