Central bank digital currencies will make foreign exchange transactions less risky

The foreign exchange market is subject to significant credit and settlement risks. Although risk mitigation mechanisms are in place, it is estimated that about a third of foreign exchange settlements occur without these mechanisms them. Ousmene Mandeng writes that The introduction of central bank and other digital currencies can lead to a completely new settlement approach that collapses the FX lifecycle and frees transactions from credit and settlement risks.

The foreign exchange market is the largest segment of the financial market worldwide. It has an average daily turnover of $7.5 trillion and covers most aspects of economic activity.

Now foreign exchange demand is influenced by the increasingly complicated international economic environment. No other market appears to be more vulnerable to disruption and could benefit more from the inherent properties of digital currencies. Digital currencies enable a new settlement approach that could reduce risk and bring important efficiencies to the foreign exchange market.

Exchange rate risks

Due to high trading volumes and lack of diversification, the foreign exchange market is subject to significant complexities and risks. The ten largest institutions account for two thirds of the transaction volume. Currency concentration is significant and the US dollar is a side in nine out of ten currency pairs. There are significant credit and settlement risks. While it is possible to minimize risks, it is estimated that about a third of foreign exchange settlements occur without risk mitigation. Processing is subject to significant delays and typically takes two days from execution, but may take significantly longer.

Foreign exchange trading involves the exchange of two amounts of money, each denominated in a specific national currency, at a fixed exchange rate. The foreign exchange lifecycle usually distinguishes between execution, clearing and settlement. Netting is the consolidation of multiple transactions with other financial institutions so that a single net amount can be received or paid out.

To process a transaction, payments are typically made in the Large Value Payment System (LVPS) of the country whose currency is being exchanged. Since banks typically do not have access to foreign LVPS, they must make or receive payments through correspondent banks.

Credit risk is countered by minimizing the risk to the counterparty. Banks do this particularly through netting, as shown above, and by setting aside capital to absorb possible losses. Settlement risk is mitigated through payment-for-payment mechanisms to ensure that funds are only exchanged when both can meet their respective obligations. The risk increases with the time until settlement.

CLS, an independent multi-currency settlement system, provides important risk mitigation mechanisms through multilateral netting and payment-versus-payment arrangements. Only 18 currencies can be transacted via CLS. Multilateral netting reduces average funding to only a small fraction of the amounts traded. However, the netting itself involves credit risk and is subject to significant systemic risk.

Banks maintain large amounts of regulatory capital as a liquidity buffer to address credit and settlement risks and maintain their liquidity coverage ratios (LCRs), a measure of a bank’s ability to meet its short-term obligations. The capital that banks have to meet these obligations in the event of a distressed situation is known as high-quality liquid assets (HQLA). These reserves incur an opportunity cost, which is calculated as the difference between their return and the banks’ target return on equity.

Banks in the euro area hold around 3.8 trillion euros in HQLA. It is estimated that around 10-30 percent of HQLA is intended to cover intraday liquidity deficits. The amount allocated to foreign exchange is not typically disclosed, but is estimated to represent a significant portion of intraday liquidity needs.

Central bank digital currencies

The introduction of digital currencies can lead to a completely new approach to settlement. Digital currencies here mean currencies that are issued in a tokenized format on the blockchain. They can be exchanged like cash, breaking down the foreign exchange lifecycle where execution equals settlement and every transaction is settled on a gross basis. Transactions can be settled instantly and atomically, meaning either both parts of the transaction must be successful or neither must be successful (payment versus payment).

The combination of central bank digital currencies (CBDC) or other high-value settlement tools and instant and atomic settlement means that foreign exchange transactions are no longer subject to credit and settlement risks.

The use of instant and atomic settlement means that each bank’s position is always balanced. One part of the transaction finances the other part. In an instant environment there are no delays and one operation can follow another (nested operations). The purchased portion (the currency being purchased or received) can be immediately exchanged for another currency (e.g. in a swap), thereby creating or restoring the desired currency risk. The conditions create an environment in which the velocity of money becomes infinite, resulting in significant liquidity savings.

It is estimated that the associated risk reductions and liquidity savings will result in significant regulatory capital savings. This could be one of the biggest sources of cost reduction for banks. If the banks in the euro area alone were to forego 10 percent of their HQLA holdings, for example, that would mean a saving of 380 billion euros in regulatory capital.

Reducing regulatory capital requirements, lower liquidity needs and introducing gross settlement would create completely new market conditions. These factors may enable efficient processing at lower volumes and could lead to increased competition as lower capital requirements would mean lower transaction costs and lower barriers to entry. This would follow the logic of real-time gross settlement for large-value domestic payments.

The introduction of alternative settlement approaches could rebalance the foreign exchange market, reducing concentration and causing smaller currencies to become relatively more attractive. The market would offer efficient settlement with significantly less concentration and liquidity. This is particularly important for currency pairs that cannot be settled via CLS. Although the new approaches are not limited to digital currencies, these currencies already have easy-to-use, out-of-the-box features to support them.

An alternative settlement approach deals solely with the post-trade process and does not alter existing foreign exchange trading and exchange rate determination. However, the introduction of digital currencies should mean that they trade at a premium to existing instruments.

While CBDCs would be ideal, there are other high-quality means of exchange as well. Instant and atomic settlement of the Brazilian real US dollar could soon be coming to a trading venue near you.

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• This blog post reflects the views of the authors, not the position of LSE Business Review or the London School of Economics and Political Science.
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