Looking Ahead: Ambitions for CLS

Talk to Joseph De Feo about continuous linked settlement (CLS), the FX settlement system, and the conversation will be liberally sprinkled with terms such as gigantic, huge and great. Something of a giant in stature, as well as reputation, De Feo has dual roles as chief executive officer of CLS Group Holdings – the company formed to develop and operate CLS and as president and chief executive of CLS Bank International – the financial institution that provides payment versus payment (PVP) for transactions arising from CLS Bank eligible currencies.

Numbers are big in the FX market, where average daily turnover in global FX transactions nudges the $2 trillion mark. CLS is out to capture the lion’s share of those transactions; De Feo’s ambition is for CLS to settle 95% of global FX transactions. He’s too canny to commit to a schedule – not surprising given the savaging CLS received in its early days when systems problems caused delays in its launch.

With those “dark days” behind it, CLS has now reached a stage where it has stunned many in the market with its success, says De Feo. Early this year it set a record for the volume and value of payment instructions settled in one day – albeit after a public holiday in the US. On 20 January, 262,756 payment instructions, with a gross value of $2.175 trillion were settled. On an average day, CLS settles between 130-135,000 transactions, worth between $1.4-$1.6 trillion.

Designed to eliminate FX settlement risk (the risk that one counterpart in an FX trade will fail before both legs of the transaction are settled), CLS enables the simultaneous exchange of value between settling parties (PVP). This allows for a higher degree of certainty in FX settlement, which occurs in a five hour real time settlement window of the overlapping business hours of the participating real time gross settlement (RTGS) systems. If the strict settlement criteria for both the payment instructions received into CLS Bank from the parties are not met, the instructions do not settle and no funds are exchanged, protecting the principal of both parties.

Eleven currencies are covered by the system: the Australian, Canadian, Singapore and US dollars, Danish krone, euro, sterling, yen, Swedish krona and Norwegian krone. By the year end, the South Korean won, New Zealand and Hong Kong dollars and the South African rand will be added to the fray. The CLS system is working “superbly well”, says De Feo and no trade has ever failed to settle or errors occurred. The technology architecture underpinning the system was recently overhauled without a hitch, enabling a more modern infrastructure to be implemented that has reduced processing times and improved resilience.

The FX market has realised benefits from CLS way beyond its original remit of eliminating settlement risk. “The reduction of settlement risk has been gigantic. But the market is also increasingly aware of improvements in operational flows and the STP benefits, particularly for third party users.” Third parties use the services of a CLS settlement member bank, and are not direct members of CLS. They include banks, non-bank financial institutions such as fund managers and corporates.

So confident is the board (comprising representatives from 22 of CLS’s shareholder banks) in CLS’s success that in April it gave mandates to CLS Group to pursue a number of strategic initiatives. These include further development of the STP benefits of CLS in order to reduce costs and increase efficiency. CLS will continue discussions with electronic platforms such as FXall and EBS and pursue best practice in the market, such as the elimination of MT300 trade confirmation messages. From the end of September 2004, best practice will be to not use a secondary matching process for FX trades settled through CLS, ie not to require receipt of a Swift MT300 message.

CLS will also look to extend its operating hours, possibly introducing a “second session” that will cover operating hours in North America and Europe, after Asian markets have closed. De Feo says extending hours to embrace same day activity in Asia that will embrace current AP currencies and the previously mentioned new entrants will also be considered.

The board is encouraging CLS Group to leverage its infrastructure, which is not only the system but also the relationship it has with central banks, its governance and legal framework, to pursue services that can deliver further value to the FX industry as a whole. For example, CLS covers spots and forwards but in the future may be extended to other FX related products such as currency swaps, derivatives, non-deliverable forwards and non-eligible currencies.

Any moves the group makes will be in measured steps, says De Feo. In the short term, the focus will be on ensuring that it captures all of the FX activity of its settlement members as well as helping those banks with their programmes to market the service to third parties. This is something of a change from recent years, where CLS did not become involved in members’ third party activities. While it does not market directly to third parties, it is willing to educate the market about the benefits of the settlement system.

Put simply, CLS has become the de facto settlement standard for the FX market, says De Feo. Its very success means that other organisations will “try to ride the wave”. The London Clearing House, for example, has mooted the idea of a central counterparty (CCP) for FX but De Feo warns that such a service would address only pre-settlement, and not settlement, risk. Moreover, a CCP – which takes on counterparty risk by becoming the buyer to every seller and the seller to every buyer – has never been attempted on a global scale equivalent to that of CLS. “Such a development is not to be feared, it is the natural outcome of the success of the CLS service,” says De Feo.

While corporates have expressed a keen interest in CLS, the fund management community has taken a little longer to take it on board. However, De Feo believes funds, particularly hedge funds, will become an important aspect of the CLS business. It will only take two or three of the large custodians to commit two or three of the larger funds to using CLS and the market should kick off, he says.

The early doubts about CLS – that it would never work, that liquidity risk would be greatly increased, as would operational risk – have largely receded as the system has proved itself. De Feo says none of the scenarios envisaged have materialised. “The FX market is very adaptable and can respond very quickly to issues without the central banks having to intervene aggressively. Liquidity may become more of an issue in the future, but over time many of these services will be priced to utilise the liquidity balance, rather than on a transactional basis. Central banks like this because it means people will be managing their liquidity much more carefully.”

In terms of operational risk, De Feo says the upgrade of the technical architecture will enable CLS to deliver the appropriate levels of support to the market and is confident CLS can deal with operational situations very successfully.

“For the currencies we settle, we have dealt with a risk that has been overhanging in the FX markets since 1974 and the failure of Bank Herstatt. CLS has also brought discipline and standardisation to the FX market in terms of settlement and we have eliminated exposures that many banks didn’t realise they had.”