Asymmetric Risk
In Part 1 of this series we described the inequality of settlement risk from the perspective of Emerging Market Economies (EMEs) versus developed markets.
This inequality is often exacerbated for different types of client, often based on credit quality and relative power in the equation.
Banks that hold credit lines for other interbank counterparties and their corporate and institutional clients may be prepared to settle their obligations unconditionally, without needing assurance of purchased funds being received first. But for many customers, banks operate a policy of “I will pay you once you’ve paid me.”
The Pros and Cons of Safe Settlement or DvP
This generally manifests in customers having to pre-fund, i.e. settle in advance of the settlement date and hold funds on account, with a high liquidity overhead, or alternatively receive their funds after value date, which may impair their ability to settle onward obligations and adds to costs.
This practice is variously known as “DvP”, “Safe Settlement” and other localised terms. It can “genuinely” be considered to be more efficient than unconditional settlement, as it eliminates 50% of the settlement risk of the transaction.
However, it creates an asymmetric risk against one party to the trade, and adds funding and liquidity costs for that party. Settling transactions late due to conditionality may breach the legal contract between parties to settle on a specific mutually agreed day, but it is prevalent nonetheless.
Corporate and institutional FX market participants investing in Transaction Cost Analysis (TCA) on their FX executions to identify almost negligible execution slippage may be missing a much larger invisible cost in hidden settlement charges.
Banks also have a hidden cost of “safe settlement’ as it is usually managed as an exception to unconditional settlement (where payment processes are automated), and so generates an operational overhead.
Settlement Circle’s Settlement Optimisation Service (SOS) ensures that both parties have the tools to settle their trades on a conditional basis, with full principal protection, and levels the playing field for all participants. Come and talk to us about how it can help your FX business.
By Declan Clements, November 2021
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