What has CLS got to Offer the Corporate Client?

Introduction

CLS – the continuous linked settlement process – is a way in which firms can settle foreign exchange trades with no settlement risk. FX settlement risk is also called “Herstatt” risk, due to an event in the FX markets where Bankhaus Herstatt opened for settlement, accepted in the currencies that they had purchased, and then went out of business, without paying out any funds that they owed.

Among the world’s clearing systems, gridlock followed, and other firms suffered (one even collapsed) as part of a domino effect.

CLS introduces the payment-versus-payment methodology to FX settlement. Trades settle at the CLS Bank only if both counter-parties pay in the amounts that they owe. Then, CLS Bank swaps the pay-in versus the payout via a simultaneous exchange of currency. If one counter-party fails to pay in correctly, CLS can simply return the paid in funds to the non-failing counter-party and FX settlement risk is eliminated.

CLS is a Success

CLS successfully went live on 9 September 2002 with 39 settlement members. A settlement member of CLS is a shareholder of the CLS holding company:

• who has paid a subscription fee of $5m to join CLS
• who must maintain stringent credit-worthiness and
• who must pass an operational certification test

Some of the CLS shareholders have opted out of settlement membership, and instead have become third party participants of CLS. Third parties are an important part of the overall CLS programme. After a brief shakedown period for CLS, third parties were allowed to go live on 4 November 2002. A third party does not have to:

• be a shareholder of CLS
• pay a subscription fee to join
• maintain any specific credit worthiness requirements, nor
• pass an operational certification test

However, a third party participating in the CLS process must designate a settlement member who can provide trade submission and settlement functions. (Think of the designated settlement member as an intermediary bank.)

It is generally agreed that the size of the third party market will dwarf the number of settlement members market, because third parties can include commercial banks, central banks, brokerage houses, non-bank financial institutions, and corporations.

Current Status

Live since 9 September 2002, CLS has reached a level of industry acceptance in a very short time, with 71 shareholders, over 50 shareholders participating as direct settlement members, and 150 third parties. At the time of writing, CLS settles more than 135,000 transactions a day, worth in excess of $1.56 trillion. Peak day volume has been recorded at 262,756 transactions on 20 January 2004. Peak day value has been recorded at $2.263 trillion on 16 June 2004. To put this into a larger perspective: from inception to the end of June 2004, CLS has processed 38,760,068 transactions worth in excess of $418 trillion.

Even the number of eligible currencies is growing: from seven currencies in 2002, to a potential of 15 by the end of 2004.

Clearly, CLS is up-and-running and has become the preferred method of settling trades in the foreign exchange marketplace. In fact, it is now estimated that 60 per cent of the world’s foreign exchange settles within CLS.

Benefits

The number one benefit that CLS attempted to provide was a reduction in foreign exchange settlement risk. With $1.5 trillion settling safely every day via a payment-versus-payment methodology, this goal has definitely been accomplished.

However, while the reduction of FX settlement risk (as in the CLS settlement process) protects against the loss of principal during settlement, this reduction could also lead to a lower usage of intra-day credit. For instance, FX counter-parties may not include the entire notional value of a trade into their usage calculation or their intraday settlement lines – if the trade is destined to settle within CLS.

While we have not seen differentiated market rate (or two tier pricing) take place yet, it is possible that those firms that do participate in CLS could be favoured when executing a large volume of trades, or even a large-value single trade. Ultimately, in the inter-bank market, CLS-enabled counter-parties could become the preferred counter-parties. Certainly, from a risk management point-of-view, a firm would prefer to trade foreign exchange with a counter-party with lower risk.

Moreover, there are operational benefits from participating in the CLS process. The multi-lateral netting effect provides lower operational costs due to the sharp reduction in:

• the number of payments to be effected
• the number of receives to be reconciled, and
• the amount of processing costs and correspondent banking fees.

The multi-lateral netting effect also provides enhanced liquidity management by settling a net currency position within the large group of CLS-enabled counter-parties; rather than on a transaction-by-transaction basis. CLS has reduced funding needs for some participants by up to 90 per cent. In addition, treasury managers can have early notification of a trade’s settlement status: un-matched, matched, netted and/or settled.

One of our corporate clients has pointed out the straight through processing (STP) benefits that can help reduce costs, as well as increase speed and accuracy throughout the processing of an FX trade. This corporate client has even re-engineered his firm’s entire end-to-end process – submission, confirmation, matching, netting, and the settlement of his foreign exchange trades are on an automated basis, with CLS as the central point for all steps.

New Participation

From the beginning, there were a lot of commercial banks in the CLS process. Broker-dealers and other investment houses also joined.

Today, there are other types of institutions participating in the CLS process. We have seen insurance companies, and even the first central bank participate in CLS during the first quarter of 2004.

We, at HSBC, were very excited when the first corporate institution went live in CLS (during the second quarter of 2004). Today, this corporate institution has brought live seven additional offices; these eight different entities now cover seven different legal jurisdictions.

Moreover, the first so-called fourth party institution went live this year, via a third party service and web-tool.

Is CLS Right for your Organisation?

In the end, you must decide if CLS processing is appropriate for you. The questions that we generally use as qualifiers are very straightforward.

Does your firm execute any FX deals? If you are fully US dollar based, for instance, and you have no import or exports, then you probably do not have any FX deals. Then you probably do not care about CLS.

If you do execute FX trades, but only a few per month, then you may not care about CLS.

However, if you have a large volume of FX trades – or you execute large value FX trades – then you might be interested in CLS and how it may benefit you. Today, we have had discussions with clients who execute various volumes of trades – from ten a day to 3,000 a day.

One target client of ours has very few trades a day, but each one can be worth hundreds of million of dollars. The client is worried about its settlement exposure: the risk is that it will be in non-receipt of hundreds of millions of dollars.

You should also assess whether FX trading is a business line for you. If FX is important to you, or if you are important to the FX marketplace, then you should look at CLS processing for your FX trades. Another development that we are seeing is some corporations that are looking to reduce their currency exposure. We see greater corporate concentration on currency exposure risk since being required to report currency transactions as part of the annual report: for instance, foreign currency transactions under the FAS 133 – accounting for hedging transactions. One potential corporate client – a manufacturing company – reported $129m in FX profits in one year. Many of our clients are receiving settlement risk questions from their shareholders, their regulators, and their auditors. CLS may be a solution for them, and for you.

Moreover, we are discussing with our external auditors and our internal compliance staff about CLS and possible ramifications around the Sarbanes Oxley act. For instance, at its simplest, Sarbanes Oxley will require a corporation to certify that:

• it has identified a risk
• it understands that risk
• it has designed processes to minimise that risk
• and that it follows those processes to minimise the risk

If one of the risks that you identified is relating to the uncertainty of settlement, then CLS may be a solution for you.

Summary

The take-away messages are easy to summarise:

1. CLS is live and very successful
2. Global banks are supporting CLS with their own trades, as well as the trades of our third party clients.
3. Corporates can be in CLS as third parties, and benefit from:
• FX settlement risk reduction
• Reduced expenses
• Enhanced liquidity management, and
• Better straight through processing

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