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FRM Part II · FRM Exam Part II · Margin (Collateral) and Settlement

Which feature of a payment-versus-payment (PvP) settlement mechanism, such as that provided by CLS, most directly eliminates principal risk in foreign exchange settlement?

The key feature is conditional linkage of the legs: each currency payment becomes final only if the offsetting payment also settles. This removes the possibility of delivering one currency without receiving the other, which is what principal settlement risk is, unlike netting or margining, which do not link the legs.

  1. AEach leg of the trade is final only if the other leg is also settledCorrect
  2. BTrades are netted bilaterally before the value date to reduce the number of payments
  3. CCounterparties exchange variation margin daily on all open FX trades
  4. DPayments are made in real time on a gross basis through central bank accounts without linkage

Explanation

PvP links the two payment legs so that one is irrevocable only if the other occurs, removing the chance of paying without receiving. Netting reduces gross amounts but does not link the legs. Margin addresses replacement risk, and unlinked RTGS payments leave principal risk.

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