January 23, 2023

Why the Increased Adoption of PvP Settlement will Enhance Cross-Border Payments

Wholesale payments between financial institutions make up by far the majority of total cross-border transactions by value.

Typically, they are high-value or high-volume interbank payments. It is this wholesale, interbank foreign exchange (FX) market that provides the fuel and liquidity for domestic and international retail schemes to operate, but in doing so it is open to what’s known as settlement risk; the risk that the payment from one side won’t be fulfilled while the matching payment from the other side is already made or irrevocably committed.

Given the significant innovation that has increased efficiency in high-value domestic payment systems, enabling seamless transactions within a single jurisdiction, it’s quite incredible that it still requires, on average, one to two days to move wholesale money internationally, as well as manual intervention to supervise such transactions on systems that aren’t functional 24-hours-a-day. In spite of significant effort from many market players to innovate in this area, there have been mere incremental improvements as opposed to any true innovation or resulting step-changes.

With more than half of the world’s cross-border transactions currently taking place without an adequate safety net, Payment versus Payment (PvP) is a solution that ensures one side of the transaction gets paid at the same time as the other, eliminating settlement risk and reducing friction. There is huge appetite among global central banks to increase the adoption of PvP settlement arrangements, which makes now a good time to explore why and how this can be achieved to ultimately remove a key component of the friction that has plagued the interbank wholesale FX market for decades.

"PvP eliminates FX settlement risk because it creates simultaneous exchange of the currency ownership, which can only take place once both sets of funds have moved, providing the assurance that one party continues to own their funds until their counterparty has met their transfer obligations."

Why do Cross-Border Payments Pose Challenges?

Approximately $6.6 trillion in FX payments, on an average day, is subject to settlement risk. This is largely due to legacy infrastructure and outdated processes not being fit for the modern age, and because of the rising volume of emerging market currency FX. What’s more, the murky nature of liquidity makes it difficult to transact with certainty, making it costly. As a result, the sector is exposed to high costs and inefficiencies, with friction at many points in the payment process.

This issue was thrust into the spotlight late last year in a report from the Bank of International Settlements (BIS), “FX settlement risk: an unsettled issue”, which revealed that in April alone, $2.2 trillion of daily FX turnover was subject to settlement risk – up from $1.9 trillion in the same month in 2019. Raw evidence of a problem that’s only increasing.

Although shocking, these findings demonstrate why this unsettled issue remains front of mind for the world’s supra-national authorities. Awareness and education is the first step to creating real change, especially as a lack of standardisation around a widely accepted approach to FX trades is making it harder for policy makers to anticipate the next financial crisis.

A lack of choice in settlement arrangements designed to mitigate risk, combined with a concern among market participants that existing solutions can be costly and inflexible, create a growing market appetite for an accessible solution that ensures one side of the transaction will always get paid at the same time as the other.

PvP: the Landscape So Far

In short, PvP guarantees both parties involved in a transaction get paid at the same time as one another. Settlement of this nature is already being offered by some market incumbents, but there is a constraint; these solutions only accommodate a restricted number of currency corridors and have failed to recognise the importance of the growth in emerging market currencies. Alternatives to incumbent offerings often necessitate a migration of core infrastructure to an entirely new processing model (for example, distributed ledger technology) or require the use of a digital asset such as a stablecoin or cryptocurrency, which many banks just aren’t ready for.

Banks are known for having complex and outdated legacy systems, so what’s needed is an approach with width (for example, a large number of currency corridors covered), depth (i.e., the provision of basic accessibility requirements) and ultimately a low financial, risk and technical threshold for participation, both for currencies and participants.

For this to work however, banks must be educated on which options to choose and be willing to consider a number of key factors. The first of these is the quality of liquidity they wish to transact in, such as central bank funds versus commercial bank funds. Central bank funds, or High-Quality Liquid Assets (HQLAs), offer by their very nature the lowest risk profile. Some solutions on the market offer settlement backed by central bank funds, while others are limited to commercial bank money – which option, or options, is best suited to a bank will depend on a number of factors including the business model of the settlement provider, the currency corridor and the timeframe for settlement.

Banks must also consider that some solutions convert fiat currency (sold) into stablecoins, and then stablecoins into fiat currency (bought). This is an unnecessary conversion introducing risk and friction, such as who the stablecoin market maker is and how trustworthy they are. Unless the conversion from currency sold to stablecoin and stablecoin to currency bought is a singular instruction, there is settlement risk. Banks may or may not choose to embrace stablecoins or digital assets themselves, but another way in which cross-border payments could potentially be achieved is through the use of central bank digital currencies (CBDCs). Despite a number of trials in different markets however, there aren’t many live examples, so we are certainly a way off this option becoming a true reality.

Ultimately, despite the solutions currently circulating in the market, as seen from the BIS report, we are still witnessing a massive proportion of daily payment obligations stemming from interbank FX trades settling with the risk that one party of the trade won’t fulfill its obligation to its counterparty. More needs to be done to solve this problem.

PvP’s Role in Creating More Efficient Cross-Border Payments

Although existing PvP arrangements in the market have made significant progress in reducing settlement risk, there has been an increase in areas of the FX market that remain unsupported. Also, as the cross-border payments market moves towards real-time settlement, users’ demand has increased for real-time PvP services that enable fast and reliable access to liquidity in foreign currency.

PvP eliminates FX settlement risk because it creates simultaneous exchange of the currency ownership, which can only take place once both sets of funds have moved, providing the assurance that one party continues to own their funds until their counterparty has met their transfer obligations. This process means that the decision as to when to settle those amounts via PvP is a bilateral decision that falls to the settlement participants, who are able to effectively align settlement timeframes to meet their funding requirements. This approach allows settlement to happen on-demand, 24/7 and 365 days per year, without the liquidity constraints that concentrated prefunding introduces.

Creating a Resilient Financial System for All

While building safety, soundness, and resilience across the financial market is the priority, there is no miracle cure for the problem. Finding a true solution requires collaboration of multiple public and private sector stakeholders.

The challenges of wholesale cross-border payments provision are multi-faceted, so when it comes to tackling these, the transfer and exchange of currencies around the world must be built on what works today, but also future-proofed for the digital age and future currencies. What’s needed are cost-efficient, streamlined, and secure capabilities not only for interbank PvP, but also cross-border liquidity management, global commercial payments, and more. Get this right, and we will be on the path towards solving both current and future market challenges and ensuring a resilient financial system for all.

What does this look like in terms of a technology solution? In our view, it’s a next-generation Financial Market Infrastructure (FMI) that makes PvP settlement possible for virtually any currency corridor, enabling atomic bilateral settlement between commercial and central banks based on the real-time availability of liquidity, supported by ringfenced central bank reserves allocated to the global payments network.

Innovation in the wholesale cross-border market has left much to be desired when compared to that in domestic payments. However, we expect a rapid increase within the next five years due to serious interest and demand from central banks for a solution that allows cross-border payments to be instant, affordable, universal and secure. We will undoubtedly see a healthy choice of options and opportunities for banks, but to capitalise they must be informed as to where, when, and how to adapt if they are to successfully adopt PvP and revolutionise their cross-border payment settlement processes.

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