How Australian superannuation funds mitigate FX settlement risk
Due to an overall increase in pension assets during the past decade, pension funds have cemented their status as one of the largest asset owners globally. As a result of the pension industry’s growth, asset globalization and higher foreign content in domestic portfolios continues to rise. Traditionally, pension funds have invested in bonds and equities, but in recent decades, under increasing pressure to support an aging global population, their fund managers have diversified portfolios. This is both in terms of asset classes and geography, increasing foreign investments to gain access to flourishing foreign markets in order to support the growing number of people who rely on their yields.
The rapidly growing superannuation industry in Australia is also demonstrating similar trends and is now the second largest pensions market in Asia Pacific, after Japan. Despite the current uncertain environment as a result of COVID-19, the underlying global themes across pensions prior to the pandemic remain intact.
The industry over the years has come under heightened pressure to expand funds globally, leading to the diversification of investments to offshore assets and, therefore, a higher exposure to foreign currency in superannuation portfolios. Findings from National Australia Bank’s (NAB) ninth biennial Superannuation FX Hedging Survey, which was conducted in 2019, showed that 72% of respondents planned at that time to boost their international investments over the next two years.
Where this leads to additional FX exposure for funds, there is a potential increase in exposure to FX settlement risk. This is when a superannuation or their appointed asset manager makes payment of the currency it has sold but does not subsequently receive the currency it has bought.
As per the 2019 Triennial Survey by the Bank of International Settlements (BIS), higher daily turnover in the FX market indicates that on any day around USD9 trillion of global payments are exposed to settlement risk. The reason that such a high number of these transactions are at risk is because a large majority are not currently being settled through payment-versus-payment (PvP), which ensures that both sides of an FX trade settle simultaneously. This mitigates the risk that would exist if each side was settled independently through a correspondent bank channel, as it ensures that the final transfer of a payment in one currency occurs only if the final transfer of a payment in another currency takes place.
Whilst the recent market volatility during the COVID-19 pandemic has certainly required more institutional investors to consider their settlement risk management, the FX Global Code of Conduct (the Code), a set of best-practice principles launched in 2017, is helping to encourage market participants to assess their current processes including risk mitigation strategies and look to mitigate that risk wherever possible.
Even as a significant number of FX market participants are committing to the Code, the BIS Markets Committee has urged more participants in the FX market to implement the Code. As it stands, the Australian FX Committee has endorsed the principles as the standard for the local FX market and some super funds have already signed statements of commitment to adopt the principles. However, there is still a long way to go.
In recent years, we have seen many buy-side firms become more aware of the risks associated with FX settlement, and as such, they are choosing to become more involved in how they manage those risks, with progressively more asset managers and super funds starting to bring their FX activities in-house. However, unless they are settling their FX payments on a PvP basis, settlement risk could still be present. All fund managers, large or small, should be enquiring about the likelihood of settlement risk and, if there is a chance that the fund may be exposed, how this risk will be mitigated.
In Australia, it is important for funds to be able to demonstrate governance and controls, protection of member interests, and safety of assets. Therefore, it can provide comfort to superannuation stakeholders, if the fund is able to provide evidence that these principles are being adhered to through best practice in operations and risk management, such as the adoption of a PvP settlement service to mitigate FX settlement risk.
In a time where the macroeconomic and regulatory landscape is constantly evolving, challenged by industry pressure to maintain liquidity, reduce cost and fees and investor risk brought on by the COVID-19 pandemic, it is important to have certainty in protection relating to FX payments, in spite of the uncertain environment superannuation funds and buy-side firms globally find themselves in.
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