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How Payment-Versus-Payment Makes the Forex Market More Secure

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The currency market, also known as the Forex or FX market is the world’s biggest financial market, with a daily trading volume of several billion US dollars. But the settlement of FX transactions does come with risks. In the paragraphs below, you’ll discover how banks can reduce this risk and learn what a German bank in the 70s has to do with it.

The “Herstatt risk” is the risk that one party in a foreign exchange transaction pays out the currency it sold but does not receive the counter-currency it bought. The name of this settlement risk, also known as “principal risk”, refers back to the case involving Herstatt Bank in 1974. The bank speculated heavily in currency options, particularly the US dollar. One morning, Herstatt Bank received payments in German marks and sold US dollars in return. But due to the time difference, the US payments systems weren’t open yet, and the payment in US dollars wasn’t processed. In the meantime, the German banking regulatory authority withdrew Herstatt Bank’s license, and the bank had to declare bankruptcy. As a result, Herstatt Bank received the German marks, but the counterparty did not receive any US dollars. 

How Does the Forex Market Work?

The FX market is a global network within which currencies are traded. It features an average daily trading volume of 7.5 billion US dollars (2022), and is managed decentrally. Different from equities, which are traded at specific stock exchanges, forex trading is conducted via a network of financial institutions. Trading is possible around the clock five days a week.

What is Payment-Versus-Payment in Forex?

Following the Herstatt incident, new mechanisms such as Payment-versus-Payment (PvP) were introduced in order to reduce the settlement risk in foreign exchange transactions. These risks occur because payments in different currencies aren’t processed simultaneously. As the Herstatt Bank example shows, the eponymous Herstatt risk (or principal risk) occurs when one party delivers a currency, but the counterparty does not fulfill their obligation. PvP eliminates this risk by ensuring that a payment is settled simultaneously and irrevocably only if the counter payment is made.

How Is Payment-Versus-Payment Implemented?

By involving a central counterparty (CCP), payments are no longer made directly between the counterparties, but via a neutral entity. The task of the CCP is to ensure that both parties fulfill their obligations before final settlement takes place. This minimizes the counterparty risk and ensures that foreign exchange transactions are settled in a proper and timely fashion.

What Happens If a Payment Is Not Made in Foreign Exchange Trading?

If a party fails to meet their payment obligation, the transaction is flagged as “failed”. If the counterparty has already paid, the CCP ensures that the funds are returned, thereby eliminating principal risk. The defaulting party is sanctioned in order to compensate for any potential losses the counterparty may incur. Moreover, the failed transaction is reported to the relevant regulatory authorities.

Payment-Versus-Payment and T+1

The move to T+1 for the settlement of US securities means that investment funds and institutional investors have to process their forex transactions within a single work day. For many market players, efficient PvP settlement can solve this challenge.

Secure Payment-Versus-Payment with FXS

The Spanish Central Bank has authorized SIX to launch a PvP-based payments system across the EU. FXS enables smaller banks to eliminate principal risk and hedge their forex trades.

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