Two years have now passed since continuous-linked settlement (CLS) was first brought to bear on the financial services industry, it is clear that this specific market is on the precipice of change. Rapid uptake of CLS means that it has become the standard for cash settlement – a reality that is no longer limited to just the FX world. As new investment products begin to take advantage of CLS benefits, the importance of adoption by major banks is taking on a new urgency.
CLS is focused on eliminating settlement risk, and while it does not reduce all forms of risk – such as credit and liquidity – it does bring more control to the overall process. Side benefits have also been reported, such as straight-through-processing rates increased in association with automated matching, a noteworthy reduction in numbers of payments, and an increase in reconciliation efficiency. Each of these items alone aids businesses – together they bring about significant opportunities to reduce back office costs.
Given the industry response, the approach can be officially dubbed a success. Most foreign exchange trades are settled through CLS, and volume growth has exceeded all predictions, with $1 trillion dollar days now considered the norm. As use continues to climb, the number of currencies settled by CLS is also growing, and new products like money markets and securities are being included.
Despite this powerful momentum, some banks still question their initial CLS strategy. The cost of maintaining a third-party service is substantial, encompassing a processing centre, client support, sales and marketing, and systems that must consider technology requirements above and beyond settlement issues. Banks are therefore assessing the continued viability of third-party offerings and vendor relationships, as well as the efficiency and modernisation of internal systems development. Also taking into account subsidiary business gains that are provided by CLS and the potential for consolidation and outsourcing, they are looking to ensure that CLS is indeed the most durable solution available.
In response to these efforts, some banks have cancelled third-party projects, and some that originally planned to serve as settlement banks have ended up outsourcing their processing to another provider. In essence, as the second round of CLS evolution has begun, banking leaders are reviewing their initial decisions and trying to gauge the market’s direction and the cost that can be justified to lead them there.
In reality, the advantages should be well worth the expense. Ten years from now, CLS could be settling more than 75 per cent of the cash side of cross-border securities trades. Leading the interest is CLS’s ability to eliminate settlement risk, increase STP rates and account for large increases in reconciliation efficiencies.
The Current Market
The payments market is still led by the strength of tier one providers and the competitive fire of lower-tiered competitors. The gap, however, continues to widen between those who develop an offering with value-added services and those that regard payments as simply the settlement of transactions. The big payment banks with the most liquidity and best technology have centralised services into one-stop-shops, which requires the use of sophisticated tools to bring together disparate services. For example, CLS members who have a successful third party service offering can maximise profits by cross-selling cash management and payment services as part of integrated service.
Such top tier institutions are defined as CLS settlement members with a viable third party offering and an integrated global liquidity and cash management offering. A second tier is comprised of CLS settlement members who have developed a third party offering, but have not had as much success in attracting clients. Third tier participants are settlement banks that have not developed a third party offering and are dependent upon outsourced solutions. Also in the mix are banks and corporates that have decided to serve as a third party member of CLS and, of course, companies that are not yet connected to the approach.
With the current and future potential of CLS accepted as indispensable, providers throughout these tier groups must make key decisions on how much they are willing to commit to offering the service. As far as the struggle for top seed, it is clear that CLS leadership is a matter of volume. Top tier institutions retain their stability not through sheer number of mandates, but through the consistently high volume inherent in each CLS project. In fact, with 52 per cent of third-party volume managed by only two settlement banks and 96 per cent being managed by the top seven, the general consensus is that a very small number of banks will succeed and become the agent of choice for other settlement members and third party clients.
For banks that require third-party assistance, there are a number of factors to consider as they investigate their options. Chief among these is relationship and client support; it is no coincidence that the leading providers all have large sales forces. In addition, size of client base is a key differentiator, as it determines whether the offering is and will remain viable; the amount of committed liquidity indicates whether they will be able to extend sufficient credit to clients; and the right technology is of course essential to providing solutions to the myriad business questions involved in an integrated, one-stop-shop offering.
Regardless of who climbs into or remains a fixed member of the top-tier group, there is still industry work to be done in order to solidify CLS as the long-term industry standard. Central banks, regulators and settlement members should work together to increase the number of CLS participants and as such reduce the large operational cost of maintaining settlement procedures for CLS and non CLS activity.
The effect of taking no action will be the most damaging of all, both in terms of cost and market standing. Because while making money from third parties is only a reality for top tier institutions, there is no doubt that tapping into CLS – whether through internal initiatives, joint ventures, or outsourcing – will soon be a requirement of trade settlement. Looking ahead, if you are not in the CLS world, you are not part of the core FX market.