Payment Versus Payment

Payment versus payment, usually shortened to PVP, is the principle that the two legs of a foreign exchange transaction should settle simultaneously, so that one cannot settle without the other. If Bank A is selling euros to buy dollars from Bank B, the euro payment and the dollar payment should be linked. Either both settle, or neither settles. This eliminates principal risk, because a bank can no longer pay its side in full and receive nothing in return. PVP is the foreign exchange equivalent of delivery versus payment in securities markets, where cash and securities change hands together. Implementing PVP is technically demanding, because the two legs settle in different currencies, through different payment systems, in different time zones, and often through different central banks. The systems must be coordinated so that the settlement of one leg is conditional on the settlement of the other. This requires a trusted intermediary or a shared platform that can hold both payments and release them together. It also requires agreement on cut off times, on what happens if one leg fails, and on how the linked payments are treated in insolvency. These are legal and operational challenges as much as technical ones. Despite the complexity, PVP has become the standard for foreign exchange settlement, largely because of CLS, which is described in the next section. Smaller foreign exchange trades, and trades in currencies not covered by CLS, may still settle without PVP, and banks manage that residual risk with bilateral limits, collateral and careful monitoring of counterparties. A business analyst working on foreign exchange systems needs to know for each currency pair and each settlement channel whether PVP applies, because that determines the risk profile of the trade and the controls that must surround it. Follow one trade through CLS. A bank sells EUR 25 million and buys USD 27 million, at a rate of 1.08. Both legs are submitted to CLS, which holds them and releases them together during the settlement window in the early morning, European time. Either both settle or neither settles, so the bank cannot lose its EUR 25 million and receive nothing. Now suppose the bank's dollar leg fails, because its dollar account is short. CLS holds both legs, the trade does not settle, and the bank must re-trade at the new market rate later in the day. It loses the difference between the original rate and the new rate, which is the replacement cost, but it does not lose the EUR 25 million of principal. That is the difference PVP makes. Principal risk becomes replacement cost. For a currency pair that CLS does not cover, the trade settles gross, leg by leg, and the bank manages the risk with a bilateral settlement limit, say EUR 5 million per counterparty per day, plus collateral and careful monitoring of who it trades with. A business analyst needs a PVP coverage matrix for every currency pair the bank trades. The matrix has one row per pair, stating whether settlement is through CLS or another PVP arrangement, or gross with limits. For gross pairs the requirements should state the settlement limit, who sets it, how it is monitored intraday, and what happens when it is reached. New trades blocked, prefunding required, or collateral called. The exception flow should calculate the replacement cost automatically when a trade fails to settle, because the operations team needs that number to decide whether to re-trade immediately or wait. And the risk report should show the total gross exposure by counterparty, because a limit that looks safe per trade can be dangerous when twenty trades with the same counterparty settle in the same hour.