DLT Is Promising for FX Settlement, but Not without Challenges

DLT settlement for FX makes painful progress towards large-scale adoption. The acknowledgment of trading risk boosts interest in blockchain-based solutions. However, a number of projects have stalled or fallen by the wayside.

The volume of FX trading where there is a possibility of one or more parties failing to deliver on the terms of the trade has prompted various initiatives to find better options for settlement. In a distributed ledger technology context, the simultaneous exchange of currencies is referred to as atomic settlement.

But, after years of false starts and talk of potential, it would take a brave person to state that we are on the verge of widespread use of distributed ledger technology for FX settlement.

A paper published by Marc Glowka and Thomas Nilsson from the Bank for International Settlements (BIS), which followed the publication of its latest triennial central bank survey of foreign exchange, outlined the potential for FX settlement risk to result in significant losses for market participants, sometimes with systemic consequences.

They noted that the failure of Bankhaus Herstatt in 1974 eroded confidence in interbank relations and caused a freeze in money market lending. More recently, KfW Bankengruppe lost €300 million when Lehman Brothers collapsed in 2008, while Barclays suffered a loss of $130 million to a small currency exchange in March 2020.

Yet, the survey conducted by BIS found that nearly a third ($2.2 trillion) of deliverable FX turnover remained subject to settlement risk as of April 2022, which is up from $1.9 trillion in April 2019.

Previously, BIS' committee on payments and market infrastructures has called for innovative proposals for addressing settlement risk. Although what was not discussed in the paper referenced above is the potential for DLT to reduce settlement risk in FX markets, which has been explored in various projects.

In late 2021, BIS, Banque de France, and Swiss National Bank completed the DLT settlement for central bank digital currencies or CBDCs. Project Jura, part of a series of wholesale CBDC experiments initiated by the Banque de France in 2020, involved settling FX transactions in digital euros and Swiss francs, with the transfer of currencies between French and Swiss commercial banks facilitated by a third-party distributed ledger technology platform.

Around the same time, DBS announced that it had successfully tested FX trading using permissioned DeFi liquidity pools on a public blockchain as part of Project Guardian, which is a collaboration between the Monetary Authority of Singapore and the financial industry to test the feasibility of applications in asset tokenisation and decentralised finance.

In mid-2022, a group of 14 banks trialed Finteum's DLT-based intraday FX swap platform. But, the concept seems to have lost momentum as the launch of the Fnality platform (expected last year) has been delayed until at least Q3 2023.

“We will take a phased approach to functionality rollout in collaboration with our shareholders, and subject to regulatory approval,” explained Rhomaios Ram, the CEO of Fnality. “Single currency payments between banks will act as the minimum viable solution for go-live and the foundation for further use case development.”

Use cases recently demonstrated using proofs-of-concept, such as real-time cross-chain repo swaps and intraday FX swaps. Further, Ram said that the company is working closely with relevant business partners to identify long lead items to enable ramp-up as soon as possible after the system goes live.

According to Ram, Fnality’s rollout plans for a fully compliant accessible, and secure network of DLT-based payment wholesale systems to support the growing industry adoption of tokenised assets across global markets are continuing.

“We are engaged in detailed discussions with the Bank of England, and The Sterling Fnality Payment System (FnPS) target go-live date is the second half of 2023, subject to final regulatory approval,” he stated. “Alongside this, we are progressing towards the launch of wholesale payment systems in the US and Europe, which are on track to occur from 2024 onwards, again subject to local regulatory approval.”

The sequencing of currencies available will be driven by the timing of approval from each central bank, enabling payment versus payment (PvP) functionality when multiple currencies are live. This will also enable more complex cross-border delivery versus payment (DvP) use cases.

PvP is where each counterparty is obligated to make a final transfer of one or more currencies only if the other counterparty has made a final transfer of one or more currencies whereas DvP is a settlement that guarantees transfer only happens after a payment has been made.

HSBC was one of the participants in the Finteum trial, although a spokesperson for the bank said it had decided against signing up to the platform. However, HSBC has its own DLT-based platform, FX Everywhere, which it has used for netting and settlement of FX trades since 2018. To date, it has settled approximately $5 trillion across 13 currencies.

“In 2021 we opened FX Everywhere up to Wells Fargo bank to settle bilateral transactions,” explained the spokesperson. “We currently use it to settle USD, CAD, GBP, EUR and CNH. The platform enables participants to efficiently settle bilateral cross border obligations across multiple onshore and offshore currencies, coupled with the added flexibility of extended settlement windows to optimise PvP risk reduction opportunities.”

Of the 10 FX PvP proposals received last year by the BIS committee on payments and market infrastructures, only one is live: Baton Systems’ Core FX DLT, which is used by FX Everywhere. According to Alex Knight, the Head of EMEA at Baton Systems, there is a growing need for market participants to efficiently reconcile, net, and safely settle FX transactions for a growing number of currencies on a PvP basis.

“DLT-based solutions go a long way to enabling riskless settlement in a broad and easily extensible range of currencies right now,” he said. “More and more financial institutions are adopting actionable solutions to manage settlement exposure across a much larger range of the currencies they actively trade.”

Last November, a working paper from the IMF’s monetary and capital markets department explored the possibility of a multi-currency exchange that would centralise payments and settlement to reduce the cost of foreign exchange conversion.

However, the authors of the paper did not state that validation should be done via DLT rather than centralised databases, merely observing that the decision on the underlying technology should be made after consideration of differences in terms of cybersecurity, resilience, and governance.