SPONSORED CONTENT| Billions of dollars of Australian superannuation fund money may be exposed to foreign exchange settlement risk every single day.
A recent report by the Bank of International Settlements estimated that as daily turnover in the foreign exchange (FX) markets hit a record high last year, around US$9 trillion of global payments are exposed to daily settlement risk. This is partly because an increasing number of currency trades are not being settled on a payment-versus-payment (PvP) basis.
Settling a trade via a PvP mechanism ensures that both sides of an FX trade settle simultaneously, mitigating the risk that would exist if each side was settled independently through a correspondent bank. In other words, it makes sure that an investor is not out of pocket if the other side of the transaction falls through. According to CLS, which settles on average over US$5.5 trillion of global FX payments every day, their service is used less in Australia than in North America or Europe.
“Australia’s superannuation fund industry is still growing and evolving,” said Margaret Law, head of client management at CLS for the Asia Pacific region in an interview from Hong Kong. “They are placing greater emphasis on diversification of investments to offshore assets. This has resulted in an expanded need for FX transactions and currency hedging, which naturally increases exposure to settlement risk.”
CLS was established in 2002 with the support of central banks and the cooperation of the global FX community to reduce settlement risk by ensuring that payment instructions from both sides of an FX trade occur at the same time. It started with seven currencies including the Australian dollar and now settles payment instructions in 18 currencies including six in Asia. Its members are made up of more than 70 financial institutions, and a number of these members also provide access to CLSSettlement for over 25,000 of their clients.
With Australia’s $2.9 trillion superannuation industry rapidly consolidating into larger funds with hundreds of billions of dollars in assets, more local money is expected to head offshore, including into the emerging markets. A recent institutional survey by National Australia Bank found that 72 per cent of respondents plan to boost their international investments over the next two years.
While around 75 per cent of Australia’s 20 largest super funds already use CLS to settle their FX trades, including AustralianSuper, Law said there were other funds who were starting to invest offshore who may be less aware of what she described as the “most significant risk in the FX market.”
‘Significant’ Risk
“While the majority of larger superannuation funds are using CLS to mitigate their FX settlement risk, there are many smaller funds with fewer middle office resources that have yet to sign up for the service,” she added. “As the trend to trade offshore grows and more FX is being executed with multiple counterparties, there is an increase in settlement risk exposure among super funds that are not settling their payments through a PvP mechanism.”
Around 1.5 per cent of global FX transaction volume already occurs in Australia, according to a recent report by the Australian Securities and Investment Commission. The local dollar is also the fifth most traded currency in the world, accounting for 6.8 per cent of global daily volume, or US$455 billion a day.
According to the BIS report, the growing volume of emerging markets (EM) currency trades have added to the “significant” global settlement risk, because many of those transactions are not currently settled in CLSSettlement. EM currencies last year made up 23 per cent of global FX turnover compared to just 15 per cent in 2013.
“Even at the height of the great financial crisis, FX markets remained resilient,” wrote BIS Payments and Market Infrastructures Committee members Morten Bech and Henry Holden in the report. “However, FX settlement risk appears to have increased since 2013 in both relative and absolute terms.”
Stuart Hill, head of investment operations at Local Government Super fund in Sydney, said investment-related risk, including FX settlement, was always “front and centre of mind” for any super fund. LGS uses an overlay manager to oversee its foreign currencies exposures which in turn settle trades through CLSSettlement.
Hill said the third-party manager oversees their foreign currencies exposures for both international equities and non-Australian dollar mandated limited partnership assets. Approximately $3.5 billion is already invested offshore.
“The opportunities to invest are broader overseas,” said Hill in an interview. “Our exposure to international equities has increased because of the returns and the need to have a diversified portfolio of assets.”
While the bulk of LGS’s $12.5 billion is managed externally, Hill said best execution, including in FX trading and settlement, was paramount against a backdrop of heightened regulatory pressure to reduce costs and fees.
In-House Trading
CLS’s Law said while many funds like Local Government Super may continue to outsource their currency exposure to an overlay manager, a growing number of funds are also looking to manage FX trading and subsequent related risks internally.
“Increasingly, asset managers and super funds are bringing their FX activities in-house,” she said. “But regardless of who is managing the risks, unless they are settling their FX payments on a PvP basis, settlement risk may still be prevalent.”
The $180 billion AustralianSuper, which is tipped to grow to $250 billion over the next three to five years, already uses CLS to settle their FX trades. As Australia’s largest super fund, a large part of the portfolio is hedged and any active foreign exposure is managed through an overlay strategy. About 40 per cent of the overall portfolio is managed by the fund’s internal investment teams.
Joris Hillmann, head of capital markets at AustralianSuper, said the fund had its own panel of trusted counterparties and an overarching counterparty-management strategy. Currency is internally traded from both Melbourne and a recently-established trading desk in London.
“Because of our trading size, we think we can get better pricing, liquidity and execution timing when we trade ourselves,” Hillmann said in an interview from Melbourne.
For those funds that don’t have the resources of AustralianSuper to execute and settle their transactions, Law said there was a good chance that many, particularly those who have grown via mergers and have numerous externally-appointed managers, were unaware of their growing exposure to settlement risk, simply because they had not investigated.
“If they don’t ask their managers who trade FX as part of their investment mandate or if they don’t enquire with their FX overlay manager whether there is settlement risk and how they are mitigating it, there is a chance the fund may be exposed,” she said.
“The use of PvP should not be limited to the large funds,” she added. “Smaller funds, via their external managers, are increasingly going offshore to allocate money and in doing so, could potentially expose themselves to risk.”
Code of Conduct
And it’s not just offshore investment trends that are driving the need to manage settlement risk. The FX Global Code of Conduct, a set of best-practice principles, also encourages the adoption of PvP settlement globally. Specifically, it states that market participants should measure and monitor their settlement risk and seek to mitigate that risk wherever possible.
The Australian FX Committee has endorsed the principles as the standard for the local market and some super funds, including AustralianSuper, have already signed statements of commitment to adopt the principles.
“PvP settlement supports best practice in terms of risk mitigation and operational efficiency,” said Law. “Based on this, we believe the need for FX settlement risk mitigation services among Australia’s superannuation funds, even the smaller ones, will continue to increase.”
