Sunday, 26 May 2024

Currency settlement mechanism strengthens Korea’s financial system

5 min read

By David Puth

David Puth, Chief Executive Officer at CLS, welcomes the Bank of Korea’s call to expand protection from settlement risk in foreign exchange and highlights the efficiency and operational benefits of CLS to non bank financial institutions.

Mitigating risk in the midst of uncertainty

Managing cash flow, maintaining adequate intraday liquidity, and fulfilling payment obligations can be challenging for asset managers, securities companies, and funds given the scale of diversification that has evolved. In some cases, additional funding for settlement can be required to satisfy demand during volatile market conditions, putting further pressure on counterparty risk limits.

To avoid this and ensure protection against counterparty risk, it is crucial that the best risk management practices are embedded within currency trading organisations. This includes, among other things, settlement risk. 

Settlement risk is the risk of one party to a foreign exchange (FX) transaction delivering the currency it sold but failing to receive the currency it bought from its counterparty. The result in such an event is a loss of the principal, often many millions of dollars.

The FX market’s position is unique in underpinning the stability of businesses and international trade. The uninterrupted operation of this $5.3 trillion a day market is of a critical nature and one that stretches far beyond the trading floors of the largest international banks.

Pursuing financial stability in the Asia Pacific region

As the largest risk mitigation and settlement system for currency trading, the role of CLS is to maintain stable and orderly settlement between the thousands of counterparties trading currencies across borders every day, and protect against settlement risk.

The CLS has a long and deep history with the Asia Pacific (APAC) region. CLS currently settles six APAC currencies and the KRW has been a CLS-eligible currency since 2004. CLS currently has a strong pipeline of interest from a wide range of institutions, including securities companies and fund managers.

The FX market in the region including Korea has evolved as a result of new technology, people, and innovation. A core catalyst has been the transformative increase in participation from a diverse range of nonbanks and the diversification of investment towards foreign assets—a trend that is predicted to accelerate over the coming years. 

In addition, greater trading and economic relationships with partners, openness to foreign investment and imports, and the completion of numerous trade agreements have enabled Korea to become a vital trade partner for goods and services.

As a result, the Korean won (KRW) is now among the most actively traded currencies in APAC; an important factor in supporting cross-border trade and investment.

Korea’s expansion of CLS eligibility

The Bank of Korea has recognized that financial stability is put at risk when institutions are highly exposed to their counterparty and has taken steps to address this. This meets a key market need, addresses an important risk management policy, and provides significant liquidity and credit efficiencies.

With the trend for growing diversification of cross-border investment and consequent increase in FX trading, the Bank of Korea, in consultation with the Ministry of Strategy and Finance and CLS, agreed to expand the range of participants eligible for payment-versus-payment (PvP)  settlement to nonbank financial institutions such as pension funds and asset managers. Prior to the change, only FX-licensed banks in Korea were permitted to settle in CLS via a third-party service provider. Earlier in 2016, Samsung Securities, one of South Korea’s leading securities companies, became the first nonbank financial institution to use CLS’ services.

The story of diplomatic, economic, and technological connectivity between Korea and the world’s economies extends to the currency markets and CLS, hence this change is both welcome and timely. Closer economic ties with the European Union, United States, and China, through the completion of free trade agreements, are resulting in greater business and trade opportunities.

For nonbank currency trading institutions, settlement risk remains the single largest risk, irrespective of the size, profile, or specialism of the counterparty. This risk becomes greater when international currencies across different time zones are transacted, which is increasingly the case for Korea’s financial institutions.

This is why the expansion of CLS services to nonbanks is a positive development for Korea’s financial system. It not only delivers the trust and operational benefits of PvP settlement, but also significant operational and liquidity benefits that lower transaction costs, while boosting trading efficiency and business growth opportunities.

As a result of this move to expand protection from settlement risk, Korea’s financial system is strengthened. Korea’s financial institutions settling through CLS will now be able to operate in the knowledge that they can better manage their trading and investment strategies, cash flow, and exposures, all while knowing they are protected from the single biggest risk in currency trading.

At the same time, trading partners will benefit from the stability, security, and liquidity that domestic Korean institutions gain. These are developments which, replicated throughout the region, would help ensure a robust financial market infrastructure that is able to withstand financial shocks.

Keywords: Foreign Exchange, FX Settlement, Nonbank, CLS, Currency Risk
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