A New Look at CLS and Corporate Risk Management
Since 2002, when Bank of America went live on CLS as a settlement member and part of the first wave of CLS banks, 99.9 per cent of the institution’s FX settlements have straight through processed. Global CLS processing volumes by settlement members are projected to grow 150 per cent through June 2005, increasing to 176,000 sides per day, which now seems likely to be achieved.
Richard J Herring, Co-Director of the Wharton Financial Institutions Center, describes Continuous Linked Settlement as the private sector’s response to bank regulators’ concerns over FX settlement risk. For many years, cross-currency settlement required a separate payment settlement of each side of a trade, with long distances and multiple time zones increasing the risk of one party defaulting before completing the payment side of a transaction. In 1974, the risk became a catastrophe when Bankhaus Herstatt collapsed, resulting in losses to banks that had made deutschmark payments in the German market time zone but had failed to receive the reciprocal dollar counter funds when the US market opened. The stakes have risen since then, as cross currency transactions have grown exponentially, with a corresponding increased risk of a domino effect across the markets in the event of a settlement failure or error.
While CLS only handles future-value date FX deals, meaning there is still a settlement risk profile for same-day deals, Web-enabled information helps provide more timely information on settlements and failures.
Since 1974, the so-called ‘Group of 10’ central bankers have worked together to identify ways to reduce the possibility of a systemic collapse in the clearing and settlement system, says Herring. The Continuous Linked Settlement initiative appears to be a fairly straightforward and welcome private initiative to reduce a potentially large vulnerability.
CLS effectively eliminates the settlement risk by electronically linking a central CLS Bank–regulated by the U.S. Federal Reserve–with real-time gross settlement (RTGS) payment networks of 11 central banks: Bank of Canada, Bank of England, European Central Bank, Swiss National Bank, Bank of Japan, Reserve Bank of Australia, the US Federal Reserve Bank, the Denmark Nationalbank, the Central Bank of Norway, the Monetary Authority of Singapore, and the Central Bank of Sweden. During a daily five-hour time window (three hours in Asia Pacific) trade funding, settlement, and payment are executed, in contrast to the traditional multi-day settlement process.
There are three primary classes of participation in CLS Bank:
Large multinationals are asking about the risk-elimination benefits of CLS, says Sue Hutchison, Bank of America Global Treasury Services Senior Vice President, Manager Foreign Exchange Products. In the post-Enron era, where Sarbanes-Oxley and other legislation have increased management focus on risk, CLS may emerge as a best practice for that segment of the large corporate market where foreign exchange is a key business driver.
As an example, she notes that one company, a US-based manufacturer, is looking at CLS as a system that guarantees settlement and protects principle of payment. With settlement volume of about $1bn per month, risk management was a major driver behind this global company’s decision to evaluate CLS, says Hutchison. Equally as important to them was operational efficiency and CLS is viewed as a method of outsourcing their FX trade settlements.
The company, which believes that corporates generally don’t worry about cash settlement nearly enough, was impressed with the liquidity management that CLS offers.
Since CLS nets across counterparties and across currencies, this company believes it could reduce liquidity required by about 85 per cent, Hutchison says. The feedback I’m getting suggests that the bank community has not effectively educated clients about CLS in general, and about the specific benefits CLS can bring to improving operational processes.
Focusing on cost savings, Hutchison says that CLS’s annual cost to corporate clients should be compared to the cost of a counter party failing or to the cost of an interest compensation claim on a single trade that is delayed.
Corporate entities should consider not only the number of trades but also the dollar volume and perceived risk around counterparty failure, she explains. Further, the time and effort to manage the volume of settlements–including processing, investigation of trades failed, and delivery instructions–could be reduced by 50 per cent. CLS really creates a scalable infrastructure.
CLS is already a best practice in the financial institutions market, and is becoming an issue of reputational risk for those institutions that do not participate in it. Further, the majority of banks have experienced improvements in operational efficiency and liquidity management.
These benefits are revealed with the results of TowerGroup’s 2003 of CLS Settlement Members, in which two-thirds of respondents reported that the rate of failed trades had dropped to zero since implementing CLS.
Wharton’s Herring adds that a settling bank makes a judgment call when it works with a bank that is not part of the CLS system. It’s a matter of standard banking judgment, he says. There are a core group of institutions that run CLS, and a larger group that relies on it. So settlement members are making credit judgments when they go beyond CLS. But even though a settling participant might make a misjudgment, the system is designed to limit the damage so it won’t ripple across the entire international banking community.
But although CLS users report positive results, the broader corporate market appears to have a limited view of CLS; and sees its value restricted to financial institutions and a handful of other high-volume FX players. The financial community itself has been focused on getting its own CLS environments up and running as well as third party banks. Corporates are now starting to ask questions and evaluate the potential benefits of joining CLS so the banks need to do a better job of communicating the CLS message to this segment.
CLS is about more than just settlement risk, for example. It also offers the ability to help streamline the entire treasury management function, and to address and improve a variety of liquidity management issues, notes Simon Gleeson, Bank of America Vice President, Securities and Product.
Pointing to the TowerGroup study, Gleeson says that CLS’s most extensive impact on global treasury operations has been a requirement to time payments carefully, both as the initiator of the FX trade and as the nostro agent.
This is due to the increased liquidity risks of participating in CLS-settled transactions, he says. Further, a significant percentage also looks upon the use of the inside/outside swap as a mechanism for managing short positions within the CLS system.
Gleeson goes on to explain that an ‘Inside/outside swap’ consists of two equal-and-opposite FX transactions between CLS Settlement Members–where one transaction is executed within the CLS system and the other is executed outside of it. Such an action leaves each institution’s net position unchanged but corrects a liquidity imbalance or short position on behalf of the initiating member within the CLS system. To reduce such risks, liquidity can be managed using two mechanisms: proactively via SEMAPHORE or passively via CLS-PETRA.
CLS has proven its value as a full treasury solution that enables companies to effectively outsource segments of their settlements, he explains. Among other value-added functions, reconciliations drop to zero, since everything matches. Our clients also find the error rate associated with high-volume trades is essentially eliminated. But there’s a slow emergence of awareness, and a lot of wait-and-see attitude. Some local banks have gone with CLS, and some seem unconcerned. Momentum is building, however.
Mike Ward, Bank of America Global Treasury Services Senior Vice President in Global Product Management, says that banks need to launch an information-based campaign to answer concerns expressed by potential corporate users.
One question that has been asked is whether or not a company will need to set up additional bank accounts to deal with CLS, reports Ward. In fact, Settlement Members that offer third party services have each developed their own operating model, which range from a single, multi-currency account, to separate accounts for each CLS currency.
He says that there are significant advantages to having individual currency accounts located in the currency center.
These accounts can be structured as separate CLS-specific accounts, with a zero balance option for existing operating accounts, or the activity can be routed through existing operating accounts, Ward said. The choice is determined on an individual basis, primarily by how the client wishes to reconcile CLS activity. If a client wants credit/debit advices and/or statements to go to a different location than the credit/debit advices and/or statements for the main commercial account then separate accounts make sense.
Concerns have also been expressed over the issue of dealing with same-day settlement of currencies that are not yet covered by CLS. Ward, though, maintains that since non-CLS activity is also processed and settled in one day, the exposure profile of settlement risk is unchanged. He notes, however, that Web enabled information reporting systems allow for more timely notification of cash settlements, rather than waiting for the overnight statement.
Currently, the Australian Dollar, Canadian Dollar, Euro, Japanese Yen, Pound Sterling, Swiss Franc, United States Dollar, Danish Krone, Norwegian Krone, Singapore Dollar and Swedish Krona have been designated as CLS Bank eligible currencies by the CLS Bank Board of Directors.
Meanwhile, the Hong Kong Dollar, New Zealand Dollar and the Korean Won–which have been endorsed in principle by the CLS Bank Board–are expected to follow later in 2004. Their acceptance, though, is subject to regulatory approval, the satisfaction of the criteria set forth in the CLS Bank Rules, and the completion of the technical implementation.
CLS is gaining momentum–an estimated 50 per cent of the world’s total FX volume is going through CLS–it’s the world’s first global settlement system, and it’s here to stay, says Hutchison. CLS shareholders and settlement members have committed an average of $5 million apiece. Plus, TowerGroup estimates that each bank has spent up to another $5 million apiece for share capital, which indicates a private-sector investment of $400-$500 million.
She notes that interest is coming from companies where foreign exchange is a key business driver.
Challenges remain though, according to Hutchison. Some corporations are concerned about communication issues, she says. For example, many CLS Settlement bank providers use SWIFT, while most corporations do not, and they want to limit the costs of migrating to a CLS environment.
She adds, that some workstation vendors are building CLS capabilities into their systems that will bridge the gap between SWIFT and other formats.
Reports indicate that a lack of straight through processing may have slowed the uptake of FX and treasury management systems, she says. In response, we are creating straight through processing for customers from the client side of the trading platforms. These will be effective for multi-bank or bilateral trading products, and will work through to the middle office and back office, including the connection to CLS.
Hutchison notes that corporations that want to deal directly with CLS through such external systems as FX portals currently do not have a direct link but there are plans in 2004 for development to provide trade data to the organization’s CLS settlement member bank.
Despite his support of CLS, Ward says he does not believe that a significant number of corporations, which can currently participate as third-party members, will ultimately take advantage of the opportunity.
Those that do will likely be trading companies from particular industries–commodity traders, for example–that can justify direct participation in terms of investment costs and project resources, he says. It is anticipated that 50 trades plus per day may make economic sense. These companies then would be evaluating CLS as many FIs are today in such terms as costs and benefits.
For the majority of corporations, he anticipates ‘passive’ participation–as corporations’ relationship banks become users of CLS either directly or indirectly, then positions created by corporate trading will, by default become part of the CLS traded volume.
It is unlikely that corporations will be forced into CLS unless corporate governance begins to look at whether relationship banks are CLS participants as part of an internal risk management process, he says. In the current climate, it’s difficult to say when or if that will occur.
Levi Strauss & Co., one of the world’s leading branded apparel companies, is one firm that has recognized that the potential benefits of CLS go beyond FX operations. But the company still isn’t quite ready to sign up for the program.
We realize that CLS can offer many efficiencies, says Miguel Silva Gonzalez, Levi Strauss International Group Assistant Treasurer. One immediate benefit is the reduction in risk exposure due to the central exchange and instant trade settlement it offers. Further down the road, cash management could benefit from the application of CLS to other types of payments. But that would be some time in the future.
He notes, though, that for Levi Strauss and perhaps many other businesses, credit is an obstacle that blocks the implementation of CLS, at least for now.
If a company wants to adopt a CLS program, it needs to work through a CLS settlement bank member, he explains. In turn, the bank needs to be comfortable with the company’s credit position. In our case, a recent refinancing precludes that–and in the current economic environment, I believe that many companies have similar challenges. Meanwhile, we continue to explore the CLS program.
Gonzalez points out that the range of benefits offered by CLS may vary by company. In some cases, CLS can streamline a business’ audit process, but that is not so important in our case, he comments. If audit controls are already built into the process, then the value-added from CLS, in that respect, may be negligible.
But he acknowledges that other CLS features can be valuable. If we consider cash management, our company already has a program that provides FX settlement confirmation from a counterparty, says Gonzalez. But although that gives us an instant view of both the system process and our preliminary end-of-day cash position, that could change if our counterparty is in a time zone, like Japan, where the transaction will not execute until the next day. While a hitch rarely occurs, it could happen, even though the trade was previously confirmed. CLS, however, would eliminate that risk on the corporate side.
Gonzales says that his company has not yet quantified the exact costs and benefits of a CLS framework. But we believe it would offer some cost reductions, since liquidity management would be enhanced, and our credit impact would be reduced for the FX segment, which would probably result in lower credit premiums. We still, however, have to explore the transaction costs associated with CLS.
Herring from Wharton adds that even among the banking segment, participation among smaller, or third party financial institutions may continue to lag. For smaller institutions, cost is an issue, and the may believe their volume does not justify the incremental costs, he says.Then again, bank regulators have carrots and sticks at their disposal that they can use to nudge these smaller institutions.
CLS, the world’s first global settlement system, is a permanent part of the financial landscape. It clearly plays an integral role in the reduction of risk exposure by making same-day settlement both possible and final. However, the realization that CLS can add value to the entire treasury management continuum is emerging more slowly. Stay tuned.
Originally published on Knowledge@Wharton, the Web-based research and business analysis journal of the Wharton School of Business.