CLS: Clear Choices for Third Parties
The past two years have seen a confirmation of the CLS proposition, with steadily increasing volumes, users and values. At the same time, an evolution of the third party market is becoming more and more apparent. For prospective third party institutions still in the process of choosing the right provider, now is a better time than ever to take stock and determine not only what CLS has brought the world, but also which providers are ahead – or running behind.
CLS is the new standard in FX settlement and CLS Bank’s ultimate goal of settling over 90 per cent of the global FX volumes is within grasp. After a somewhat slow adoption process the financial community has embraced CLS; even regions that were lagging behind until recently are rapidly becoming CLS eligible. An example of the latter is Asia. The most important Asian Pacific currencies have been added to CLS, while in India, the CLS solution implemented by The Clearing Corporation of India is bringing the Indian banking community into the CLS fold.
The influence of CLS on the FX (and not just settlement) landscape is clear. Corporations, investment managers, custodians and hedge funds, as well as the traditional bank and broker segment, are all now reconsidering their wait-and-see attitude. As the independent TowerGroup survey conducted in the first quarter of 2004 already indicates, there is a clear movement towards CLS counterparties being favoured by CLS participants. As the number of participants steadily grows, the long expected two-tier market may actually come into existence.
The market of potential third parties has enjoyed a steady flow of information, provided by CLS Bank, third party providers and independent institutions. While a large number of them have still not made their final decision, awareness of the benefits of CLS as a whole, as well as the various product offerings of the CLS providers, is relatively high. This is a notable feature of the banks and brokers market. One may wonder why the picture is so different when it comes to newly targeted markets such as the fund management industry.
The market tiering among providers of third party services is a consequence of the clearly demonstrated commitment of certain providers to the CLS industry initiatives. This shift and incipient shakeout in the third party market is actually to the benefit of those institutions that are now ready to get onboard CLS. It enables them to make a more conscious and deliberate decision as to what they are looking for in a service provider. Looking beyond the basic CLS settlement services and spotting the providers that have developed real value-added features has now become possible.
Examples of these value-added features are proven private labelling possibilities and fully flexible liquidity management products, that make the “CLS liquidity challenge” a ghost of the past.
Of the current 55 live settlement members, 25 banks have started with a CLS third-party proposition. To date 18 of these banks actually have live third parties. However, a closer look at these service providers and the clients and mandates they have demonstrates the emergence of a small number of CLS providers that are clearly in the lead.
Firstly the number of service providers that are catering to three or less third parties numbers eight out of the 18. Will those service providers that seem to have lost the third party battle manage to maintain the expensive infrastructure and service model of CLS with the revenue generated by their few clients? What decisions will they take when it comes to maintaining a 24-hour multi-lingual support centre, dealing with their liquidity challenges and the ever-continuing costs of development and maintenance of the technical infrastructure? It is highly likely that a few years down the road the smallest players in the CLS arena will face the evidence that their CLS offering is no longer economically viable and will strategically withdraw.
Further analysis also shows that some providers are active only in particular geographic or market segments. Examples would be those providers who seem to focus mainly on their own domestic markets, (Japan is a clear example), or cater exclusively for corporate clients. All in all, it is fair to say that just five out of the 18 service providers are clearly in the lead and are offering CLS third party services on a global scale and in some cases beyond the traditional boundaries of the banking industry.
As CLS has gathered critical mass, CLS Bank has been introducing new value added features and currencies to continuously expand its market share and conquer the remaining slices of the FX market. It was presumably not CLS Bank’s intention, but the unfortunate result of this expansion has been a growing segmentation between fully-committed third party providers and those who are, frankly, less so.
The most recent example of the shift in attitude of some service providers has been demonstrated by their approach towards the inclusion of the new eligible currencies. CLS Bank introduced an additional set of four eligible currencies that can be settled through the system as of December 2004. The currencies involved are the Hong Kong dollar, the New Zealand dollar, the South African rand and the South Korean won. With some minor exceptions, the first three currencies are generally accepted by the CLS community and included into the offerings of the service providers. Not so with the Korean won, however. For the moment, (pending deregulation) due to Korean regulations only onshore won trades will be permissible. This effectively means that at least one of the counterparties should be a Korean licensed FX bank. Two new Korean settlement members have joined CLS as of the go live of the won and just three other settlement members (two with third-party offerings) have upgraded their Seoul-based offices so that they are able to settle the Korean won through CLS.
This effectively means that while the current restrictions in no way inhibit CLS participants from trading won with their Korean (or Seoul-based upgraded foreign) counterparties, just two CLS service providers will be offering the Korean won as a CLS eligible currency to their third party clients. In other words, the vast majority of CLS service providers have decided to provide a less-than-full service to their CLS clients. That is why any prospective third party should ask their short listed service providers for a guaranteed future commitment to all industry initiatives.
The effects of this selective approach to adopting enhancements are likely to travel way beyond the unfortunate third parties that signed up with a provider that has not included the Korean won, though. Those third parties that are live with one of the two service providers that did show proper commitment have already voiced their dismay over the fact that this lack of industry commitment seriously inhibits them in their trading abilities. This is causing major irritation globally, which is only likely to increase. The administration of the proper standard settlement instructions (SSI) will be a laborious and annoying exercise. We are bound to see a major increase in wrongly executed settlement instructions. To make matters worse, as Korea is progressing its deregulation exercise there will be a second (and third, fourth etc.) wave of banks finally adopting the won as an eligible currency which will leave the issue of proper SSI administration nothing short of a mess.
“But I’m not trading in Korean Won, so why should I care?”
Well, you really should. The Korean won is not an isolated example of the diminishing commitment from service providers. The very same has been demonstrated already by another of CLS Bank’s initiatives, the introduction of CLS for custody-related FX.
One of the most important new drivers for FX trading volumes over the past few years has been the increase in cross border securities activity (CLS Bank estimates that it is now responsible for some 60,000 sides per day). Obviously this represents a significant portion of the FX market and as such, CLS Bank has been keen to introduce CLS to this market segment. The fund manager executes the associated FX trades with a broker on behalf of one of its managed funds, with the custodian of the fund handling the settlement. The real legal (counter) party to the trade is actually the fund on behalf of whom the transaction is conducted. CLS Bank’s systems needed to be adjusted to be able to identify the fund and match the trades based upon a common fund identification. The CLS Custody Working Group proposed a solution that fulfilled the requirements of minimal market change, minimal CLS change and SWIFT standard compliance.
The solution has been available since February 2004, but it is not really used yet because of the disappointingly sparse participation of the industry. Despite the relative simplicity of the development, nine months after CLS Bank launched this solution, only five committed members (of which only four with a third party offering) have taken it up. Where are the other 50?
This decision on the part of some service providers has far reaching consequences, which will affect all participants in the FX market. Let us not forget that custody FX is not just a service for fund managers and custodians, but it provides a solution for brokers dealing with the investment industry, to the asset management branches of commercial banks as well as governmental and corporate pension funds, insurances, mutual funds and hedge funds. If your institution is a player in today’s economy you cannot be unaffected.
The applicability of a CLS solution has hardly been as far reaching in the past, and yet the industry commitment has never been so disappointing.
Once again the CLS community is seeing a valuable proposition compromised by the lack of willingness on the part of the service providers to deliver real added value against marginal costs. The results are the same as in the case of the Korean won – irritation, serious inhibitions in trading for the few third parties that have been enabled through their provider, and insuperable SSI problems.
This low pick-up by the CLS settlement member/service provider community is preventing this solution really kicking off, as in all cases the more generally accepted or market standard a product is, the higher its chances for success.
In fact, it is short-sighted of the CLS providers not to offer this facility now, because it is clear that every business entity will need it in the future. Without it, businesses will be held back from achieving further economies of scale when it comes to liquidity savings, credit limit allocations and importantly, settlement risk elimination.
We have certainly noticed an interest by the fund management community and increasingly, questions are being asked. But it seems as though many providers prefer to wait to see how the land lies.
The approach towards the inclusion of the Korean won as well as the adoption of custody related FX through CLS shows that not every settlement member is as committed to CLS as it pretends to be. It is also to be noted that the definition of commitment includes the responsibility as a CLS shareholder as well as service provider.
The commitment of a service provider should be the most important consideration when choosing or changing a CLS service provider; those institutions that have yet to select a provider should consider requiring a commitment to comply with future CLS development as part of the request for proposal process.
At least the choices for users are crystal clear: to select a bank that makes all their decisions for them, or a provider that lets them determine whether or not they require certain functionality or currencies? Two years down the line, we think the latter group of CLS providers will be the most successful.
