home
login
contact
about
Finance Dublin
Finance Jobs
 
Tuesday, 16th April 2024
    Home             Archive             Publications             Our Services             Finance Jobs             Events             Surveys & Awards             
Smoothing the FX path with CLS Back  
Continuous Linked Settlement (CLS) is the name given to a system developed by a consortium of the world’s largest foreign exchange trading banks to eliminate settlement risk. The system allows payment netting between banks participating in the scheme and aims to provide a ‘payment versus payment’ solution in much the same way that ‘delivery versus payment’ exists in the securities markets.

Currently, inherent in every FX transaction is a certain element of settlement risk. That is, the risk that one party to a foreign exchange trade will pay out the currency it has sold but not receive the currency it has bought (because of a default by the party from whom it is buying the currency). This risk arises from the inability to link the settlement payments in such a way that the occurrence of one payment is dependent on the other and vice versa. This is further complicated by the difference in timing of payments inherent in the global cross-border payments infrastructure. Simply put, Tokyo and New York are in different time zones - a payment taking place as part of an FX transaction in one centre may have its other leg settled anything up to 12 hours later.

The classic example of this, and the case that gave FX settlement risk its other name - Herstatt Risk, is that of Bankhaus Herstatt. On June 26, 1974, Herstatt’s banking licence was withdrawn after the close of the German interbank payments system. At that time, the bank had already received Deutschemarks in exchange for US Dollars from some of its counterparties. However, Herstatt‚s correspondent bank in New York suspended activities on Herstatt‚s account prior to the US Dollar payments being made leaving the counterparties exposed to the full value of the Deustchemarks already paid. This failure illustrated clearly the domino effect created by the collapse of even a small bank as the payments systems ground to a halt worldwide. Since then, the failures of Drexel Burnham Lambert, BCCI and Barings Bank and the intervention by the Bank of England on two of these occasions to minimize the impact on the FX markets, have only served to further highlight the need for a solution to eliminate settlement risk.

During the 1990s, global FX trading volumes more than doubled to over 3,000 billion euros. In June 1994, the Group of 10 (G-10) central bank regulators, fearing the damage that a large-scale failure could have on the financial markets, formed the Steering Group on Settlement Risk in Foreign Exchange Transactions to develop a strategy to reduce settlement risk. The results of the work of the Steering Group was published in March 1996 in a report titled ‘Settlement Risk in Foreign Exchange Transactions’ - better known as the Allsopp Report.

The report showed that banks face huge exposures in the settlement of foreign exchange transactions, and that at any point in time the amount at risk from the failure of even a single counterparty could exceed a bank’s total capital. It therefore called for action to be taken on three fronts:

• Action by individual banks to control their foreign exchange settlement exposure;

• Action by industry groups to provide risk-reducing multi-currency services;

• Action by central banks to induce rapid private sector progress.

Responding to this, the self-named Group of 20 (G-20) banks was created to find a solution and developed the concept of Continuous Linked Settlement. In 1997, on the creation of the holding company, Continuous Linked Settlement Services (CLSS) in London, the G-20 disbanded and opened participation in CLS to any bank that met a number of financial, legal and regulatory criteria. As at end 2000 CLSS had 66 shareholders.

How does it work?
The services of CLSS are provided through Continuous Linked Settlement Bank (CLSB), headquartered in New York. Members of CLS will operate a single multi-currency account with CLSB across which FX trades in the CLS currencies will be settled. Non-members may access the system via a Member.

In order to settle an FX trade using CLSB, FX trade confirmations are copied to CLSB, which matches and links the two legs of the FX trade in its own systems. Currently CLS supports trading in eight currencies:

These currencies together form the bulk of all FX trading - in fact research has shown that the US Dollar alone is involved in up to 87 per cent of all FX trades.

CLS demands payments be made into members accounts in accordance with a detailed schedule - the ‘pay-in’ schedule - prepared on daily basis. Positive balances are transferred out of the account and by the end of the day, the account balance will once again be nil. Critical to the development of CLS will be the use of existing infrastructure such as CHAPS to facilitate these payments.

All settlement transactions are tested to ensure that accounts stays within three key limits:

• Short Position Limit (SPL) - limits the amount by which each particular currency can be overdrawn;

• Aggregate Short Position Limit (ASPL) - limits the total amount of overdrawn positions across currencies - will be less than the sum of the SPLs;

• The overall position on an account must be in credit.

If a settlement transaction fails any of these tests it is retried multiple times during the course of the day until it can be processed. If by the end of the day, CLSB is unable to process the transaction, it will be returned to both parties or can be rolled over to take place the next day.
Settlement processing starts at 7:00 am CET (3:00 pm JST and 1:00 am EST) and will finish at 12:00 pm CET although clearly for some currencies such as JPY and AUD, this will be earlier in accordance with local payment system operating hours.

Settlement risk
The elimination of settlement risk for currencies processed by CLS should reduce the spread charged on FX transactions involving these currencies. In order to be able to do this, member banks front-office systems will need to be able to differentiate between CLS currencies and other currencies and price FX trades accordingly. Back-office systems will also need to be altered to be able to identify FX trades involving CLS currencies and settle relevant FX trades through the CLS scheme.

As the number of actual payments required to be made under CLS is much lower, operational risks and the possibility of payment failure should also be significantly reduced. However, pre-settlement risk will continue to exist - that is, the risk that prior to settlement an FX trade is not matched with a counterparty or is cancelled as a result of a rescind instruction.

Liquidity risk

The reduced and time-based requirement for funds under the CLS system allows for more efficient use of liquidity. To support this, banks will need to invest in systems and processes that will enable intra-day liquidity management. The liquidity management strategy will need to differ from currency to currency as the demands for pay-ins in each currency will place stresses on the banks processes at unusual times of the trading day. For example, the initial demand for pay-ins in USD and CAD will take place at 2:00 AM EST and will continue through the CLS operating hours.

CLS is a major step forward and has both industry and regulator support. It is expected to reduce operational costs and narrow spreads on FX trades as well as increase the efficiency of banks liquidity management. It is also likely to spur the development of new time-based financial products.

Whilst all banks are interested in the capabilities offered by CLS, the current 66 members are those that drive the bulk of the volumes in the global FX markets. Other banks, including those here in Ireland are likely to participate as third parties through one of the Members. Regardless of the type of access to the system, Banks planning on participating in CLS will need to plan carefully and invest in new processes and systems in order to fully partake of the benefits that CLS has to offer.

Digg.com Del.icio.us Stumbleupon.com Reddit.com Yahoo.com

Home | About Us | Privacy Statement | Contact
©2024 Fintel Publications Ltd. All rights reserved.