Settlement Risk and Currency Markets

IMF Working Papers, July 24, 2026

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Settlement risk is identified as a central friction in currency markets.
The paper exploits Hungary's 2015 adoption of CLS, which introduced payment-versus-payment settlement and sharply reduced settlement risk.
Using a difference-in-differences design, the authors find that currency excess returns decline by about ten basis points after CLS adoption, consistent with lower compensation for bearing settlement risk, while exchange rate volatility also falls.
Deviations from triangular arbitrage conditions narrow, indicating a reduction in the effective cost of arbitrage and improved market efficiency.
Additional evidence based on U.S.-specific holidays supports a mechanism operating through time-zone exposure.
Conclusion: settlement risk is a priced friction and a source of limits to arbitrage in currency markets.

Identification strategy: difference-in-differences exploiting Hungary's 2015 adoption of CLS.
Natural experiment: sharp reduction in settlement risk due to payment-versus-payment settlement introduced by CLS.
Complementary tests: placebo and holiday-based evidence (U.S.-specific holidays) to support a time-zone exposure mechanism.

Currency excess returns decline by about ten basis points after CLS adoption.
Exchange rate volatility falls following CLS adoption.
Deviations from triangular arbitrage conditions narrow, signaling lower effective arbitrage costs and improved market efficiency.
Holiday-based evidence (U.S.-specific holidays) reinforces the role of time-zone exposure in the settlement-risk channel.

Payment-versus-payment settlement (CLS) reduces settlement risk by eliminating principal risk in bilateral FX settlements.
Reduced settlement risk lowers the compensation investors demand, producing lower excess returns.
Lower settlement risk and reduced time-zone exposure relax limits to arbitrage, narrowing arbitrage deviations and reducing exchange rate volatility.

Adoption of payment-versus-payment settlement infrastructures can materially reduce settlement risk in currency markets.
Reduced settlement risk can improve market efficiency by lowering effective arbitrage costs and exchange rate volatility.
Time-zone exposure matters for settlement-risk channels; market structure and settlement timing reforms can target such exposures to improve market outcomes.

Settlement Risk and Currency Markets — Seungduck Lee, Angelo Ranaldo, and Tomohiro Tsuruga; July 24, 2026; IMF Working Papers.