The foreign exchange market is a complex and dynamic arena that plays a crucial role in the global economy. It is subject to significant credit and settlement risks, which can have far-reaching implications for market participants. While there are risk mitigation mechanisms in place, a significant portion of foreign exchange settlements still occur without them. Ousmène Mandeng's insights shed light on how the adoption of central bank and other digital currencies can revolutionize the settlement process and free transactions from these risks.

Unlock the Potential of Digital Currencies in Foreign Exchange

Foreign Exchange Market and Its Risks

The foreign exchange market is the largest segment of the financial market, with a daily average turnover of US$7.5 trillion. It touches on most aspects of economic activities, but its high trading volumes and lack of diversification make it susceptible to considerable complexities and risks. The 10 largest institutions make up two-thirds of the transaction volume, and currency concentration is substantial, with the US dollar being involved in nine out of 10 currency pairs. This market is subject to significant credit and settlement risks, and although there are ways to minimize risks, about one-third of foreign exchange settlements are estimated to take place without proper mitigation. Settlement is subject to important delays, usually taking two days from execution but can take considerably longer.Foreign exchange consists of exchanging two amounts of money, each denominated in a given national currency at a set exchange rate. The foreign exchange life cycle distinguishes between execution, netting, and settlement. Netting is the consolidation of multiple transactions with other financial institutions, leaving a single net amount to be received or paid out. To settle a transaction, payments are normally made in the large value payment system (LVPS) of the country whose currency is being exchanged. Banks typically need to use correspondent banks to make or receive payments as they do not have direct access to foreign LVPS.Credit risk is addressed by minimizing exposure to the counterparty. Banks do this through netting and setting aside capital to absorb possible losses. Settlement risk is mitigated by payment-versus-payment mechanisms to ensure that monies are exchanged only if both parties can meet their respective obligations. Risk increases with the time to settlement.CLS, an independent multi-currency settlement system, offers important risk mitigation mechanisms through multilateral netting and payment-versus-payment arrangements. Only 18 currencies can be cleared through CLS. Multilateral netting reduces average funding to a small fraction of traded amounts. However, netting itself implies credit exposures and is subject to considerable systemic risk.Banks hold large amounts of regulatory capital as liquidity buffers to address credit and settlement risks and meet their liquidity coverage ratios (LCRs). The capital banks hold to meet these obligations in case of distress is called high-quality liquid assets (HQLA). These reserves bear an opportunity cost, calculated as the difference between their rate of return and banks' target rate of return on equity. Euro area banks hold about 3.8 trillion euros in HQLA, and it is estimated that about 10-30 percent of HQLA are used to cover intra-day liquidity shortfalls. The amount allocated to foreign exchange is normally not disclosed but is estimated to be a significant share of intra-day liquidity needs.

The Impact of Digital Currencies on Foreign Exchange Settlement

The adoption of digital currencies can give rise to an entirely new settlement approach. Digital currencies, in this context, refer to currencies issued on blockchain in a tokenized format. They can be exchanged like cash, collapsing the foreign exchange life cycle where execution is settlement, and every transaction is processed on a gross basis. Transactions can settle instantly and atomically, meaning both legs of the transaction have to succeed or none does (payment versus payment).The combination of central bank digital currencies (CBDC) or other high-quality settlement instruments and instant and atomic settlement implies that foreign exchange transactions are no longer subject to credit and settlement risks. The use of instant and atomic settlement ensures that each bank's position is always balanced, with one leg of the transaction funding the other leg. In an instant environment, there are no delays, and one operation can follow another (nested operations). The bought leg (the currency that is being bought or received) can be traded for another currency instantly, establishing or restoring the desired currency exposure. This environment leads to infinite money velocity and important liquidity savings.The implied risk mitigation and liquidity savings are estimated to produce sizable regulatory capital savings. It may represent one of the greatest sources of cost reduction for banks. If euro area banks alone were to forgo 10 per cent on HQLA holdings, it would mean savings of 380 billion euros in regulatory capital.The reduction in regulatory capital requirements, lower liquidity needs, and the adoption of gross settlement would produce entirely new market conditions. It may enable efficient settlement at lower volumes and give rise to more competition as lower capital requirements would mean lower transaction costs and lower barriers to entry. It would follow the logic of real-time gross settlement in domestic large value payments.The introduction of alternative settlement approaches could rebalance the foreign exchange market, reduce concentration, and allow smaller currencies to become relatively more attractive. It would offer efficient settlement at significantly lower levels of concentration and liquidity. This is particularly important for currency pairs that cannot settle via CLS. While the settlement approach is not limited to digital currencies, they already have out-of-the-box features that support such an approach.The alternative settlement approach is strictly about the post-trade process and does not alter existing foreign exchange trading and exchange rate determination. However, the adoption of digital currencies should mean they will trade at a premium to existing instruments.While CBDCs would be ideal, there are other high-quality mediums of exchange. Instant and atomic settlement for Brazilian real-US dollar may be coming soon to a trading venue near you.