What Is Payment versus Payment?
Payment versus payment (PvP) is a settlement mechanism in financial markets, particularly within the realm of Financial Market Infrastructure and Payment Systems. It ensures that the final transfer of a payment in one currency occurs if, and only if, the final transfer of a payment in another currency takes place. The primary purpose of payment versus payment (PvP) is to eliminate settlement risk, specifically known as "principal risk," in multi-currency transactions, predominantly in the Foreign exchange (FX) market. This mechanism guarantees that neither party to a transaction pays out the currency it sold without simultaneously receiving the currency it bought, thereby safeguarding against potential losses if one party defaults.
History and Origin
The concept of payment versus payment emerged as a critical response to significant vulnerabilities exposed in the global financial system, particularly following the collapse of Bankhaus Herstatt in 1974. Herstatt Bank, a German bank, failed after it had received payments in German marks from its counterparties but before it could deliver the corresponding U.S. dollars due to time zone differences and its subsequent closure by regulators. This incident, known as "Herstatt risk," highlighted the immense credit risk and potential for systemic risk in cross-border foreign exchange settlements where payments were not synchronized.9
The Herstatt crisis spurred international efforts by central banks and financial authorities, notably through the Bank for International Settlements (BIS) and the G10 central banks, to develop mechanisms that would mitigate this risk. These efforts culminated in the establishment of the Continuous Linked Settlement (CLS) Bank, which began operations in 2002. CLS Bank was specifically designed to provide a global PvP settlement service, fundamentally changing how foreign exchange transactions are settled by ensuring simultaneous exchange of both currency legs.8,
Key Takeaways
- Payment versus payment (PvP) is a settlement mechanism designed to eliminate principal risk in foreign exchange transactions.
- It ensures that the delivery of one currency is conditional upon the simultaneous receipt of the counter-currency.
- The system mitigates counterparty risk and reduces the potential for systemic disruptions in the global financial markets.
- The Continuous Linked Settlement (CLS) Bank is the predominant example of a large-scale PvP system in operation today.
- PvP enhances market stability by providing greater certainty and finality in multi-currency settlements.
Interpreting Payment versus Payment
Payment versus payment is not a value to be interpreted, but rather a structural characteristic of a settlement system. Its presence indicates a high degree of risk mitigation for cross-border payments, particularly in the foreign exchange market. When a transaction is described as being settled on a PvP basis, it means that the involved financial institutions are protected from the risk of paying out funds without receiving the corresponding funds from their counterparty. This mechanism is crucial for maintaining market confidence and liquidity, especially given the vast daily volumes in the FX market.
Hypothetical Example
Imagine two banks, Bank Alpha in New York and Bank Beta in London, agreeing to exchange $10 million USD for £8 million GBP. Without a payment versus payment system, Bank Alpha might send the $10 million USD to Bank Beta first, relying on Bank Beta to send the £8 million GBP subsequently. If Bank Beta encounters financial difficulties or operational issues after receiving the USD but before sending the GBP, Bank Alpha would face a loss of $10 million.
With a payment versus payment system like CLS Bank, both banks would send their respective currency amounts to a central clearing entity. The system would only release the USD to Bank Beta and the GBP to Bank Alpha simultaneously, ensuring that if one payment fails for any reason, the other payment is also halted. This eliminates the principal exposure for both parties, as neither bank delivers its side of the trade until the other side's payment is confirmed as received and ready for simultaneous release. This simultaneous exchange protects against the exposure period that traditionally existed between the payment of one leg and the receipt of the other.
Practical Applications
Payment versus payment is primarily applied in the settlement of foreign exchange transactions. The most prominent example is CLS Bank, a specialized financial market utility established in 2002 that provides PvP settlement services for major currencies globally. C7LS Bank processes an average of over $6.5 trillion in payment instructions daily across 18 currencies, effectively mitigating foreign exchange settlement risk for its members. T6his system is critical for market participants, including banks and other financial institutions, who engage in large-value international transactions.
Beyond foreign exchange, the principle of PvP is foundational to the secure operation of various interbank payment systems and is a key recommendation by international bodies like the Bank for International Settlements (BIS) for reducing financial risk in global transactions. T5he Federal Reserve also plays a role in facilitating secure settlement through services like the National Settlement Service, which provides finality for multilateral settlement arrangements, reflecting the broader commitment to risk reduction in payment systems.
4## Limitations and Criticisms
Despite its significant benefits in mitigating settlement risk, payment versus payment systems do have limitations. One challenge is the complexity and cost associated with establishing and maintaining such highly synchronized systems, particularly for less frequently traded or emerging market currencies. Not all currencies are eligible for PvP settlement through major platforms like CLS, meaning that a notable portion of foreign exchange transactions still settle outside of PvP arrangements, leaving them exposed to settlement risk.,
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2Another criticism or limitation relates to the incentive structure. While PvP significantly reduces principal risk, market participants may sometimes choose non-PvP settlement methods due to other commercial or operational needs, or if the perceived risk for certain transactions is deemed low. T1his highlights that even with robust systems in place, the universal adoption of PvP mechanisms remains an ongoing area of focus for regulators and industry bodies aiming to enhance global financial stability. The complexity of integrating with existing Real-Time Gross Settlement (RTGS) systems in different jurisdictions also poses an operational challenge.
Payment versus Payment vs. Delivery versus Payment
Payment versus payment (PvP) and delivery versus payment (DvP) are both mechanisms designed to eliminate principal risk in financial transactions by ensuring simultaneous exchange. The key distinction lies in the assets being exchanged. PvP specifically refers to the simultaneous exchange of two payments, typically in different currencies, as seen in foreign exchange transactions. It ensures that the payment of one currency occurs only if the payment of the other currency occurs.
In contrast, DvP refers to the simultaneous exchange of securities against payment. This mechanism ensures that a security is delivered only if its corresponding payment is made, and vice versa. DvP is crucial in securities settlement systems to prevent situations where a seller delivers securities but does not receive payment, or a buyer makes payment but does not receive the securities. While both aim to eliminate principal risk through simultaneous exchange, PvP applies to currency-for-currency trades, whereas DvP applies to securities-for-money trades.
FAQs
What is the main risk PvP eliminates?
Payment versus payment (PvP) primarily eliminates principal risk, which is the risk that one party to a transaction will pay out its side of the exchange but will not receive the corresponding payment from its counterparty, leading to a loss of the full value of the principal amount transferred.
How does PvP work?
PvP systems operate by holding both sides of a transaction in escrow, or through a central netting process, until both payments are irrevocably received. Once confirmed, the system simultaneously releases both payments to their respective recipients. This "if and only if" condition ensures that neither payment is completed in isolation.
Is PvP only for foreign exchange?
While payment versus payment is most commonly associated with and critical for foreign exchange transactions due to the inherent time zone differences and cross-currency nature, the underlying principle of simultaneous exchange to eliminate principal risk can be applied to other types of value transfers.
What is CLS Bank?
CLS Bank is the world's leading provider of payment versus payment settlement services for the foreign exchange market. It is a specialized bank that facilitates the simultaneous exchange of payments in multiple currencies, significantly reducing liquidity risk and settlement risk for its global member banks.
What happens if a currency is not settled via PvP?
If a currency transaction is not settled via a payment versus payment mechanism, it remains exposed to principal risk. This means there's a window of time during which one party has made its payment, but has not yet received the counter-payment, creating exposure to the counterparty's potential default or operational failure.