Business Opportunities in an FX World Dominated by CLS
Though progress has been made for the sell-side, the day-to-day operations to stay in this business remain expensive so the hunt for extra efficiencies and marginally lower costs never ceases. For corporates, while the cost issues may not be so dominant, the impact of SOX and the need to be seen to follow best practice is increasingly important.
Simply put, yes. Yet to date, very few of the 600 or so CLS eligible names are corporates. The third party services suppliers in the CLS market have not made as much of a marketing push to the buy-side as they have to other banks. Understandably, the banks might be thinking that the mandate will most likely go to the ‘house bank’. Should corporates, therefore, be proactive and push to get in? Yes. Firstly, because there are benefits and secondly because it is easy to do. The benefits, in short, are that a change to a single settlement method will reduce operational effort and cost and increase capacity.
Almost certainly all your sell-side counterparts use CLS and you can use a ‘one-size-fits-all’ technique. With standardization comes compliance with SOX requirements. Then there is the possibility to do other business. Plain vanilla FX business blocks the credit lines your sell-side counterparts have with you. Use CLS and those limits can be put to better use. With CLS adding new products (see below), by preparing now you will be easily able to settle NDFs (non deliverable forwards) and options in the same way (once these products are live).
No doubt about it, the impact of CLS is massive. On a peak day in FX operations, Credit Suisse’s main FX operation has to look at just 10 street-side trades out of a total of 4,500. That is STP and that translates into greater capacity and lower unit costs. There are a few gaps on the inter-bank side and there is a need for business management attention; trades that are not going through CLS distort the funding figures and add to the costs. Raising liquidity for CLS settlement costs money; if the funding numbers are distorted then there is unnecessary cost. This is easy to deal with, the rational FX business manager should be asking his operations team to measure the FX activity that is not in CLS and work to ensure that every trade that could go into CLS does so.
CLS itself is now producing monthly data to support this. On the buy-side, the picture is different. There are an increasing number of funds that are CLS eligible. One of the reasons for the delay might be that it is not clear whose interest it is in to make progress. Custodians would have to do the work, but many would rather stick to a model where they have an exclusive on the FX side and do everything in-house for the client. With the corporates, there is no really meaningful progress. Here the most obvious explanation is that there is an expectation that it will be the ‘house bank’ that would win the mandate, so there has not been full marketing as there has been in the inter-bank market. For the FX manager, the most obvious measure to take here is simply talk with the key counterparts and see what they are doing. The economics of this are simple; the cost of a buy-side ticket is roughly double that of an inter-bank one. So, get the buy-side into CLS and costs go down.
CLS is planning to introduce services for NDFs and OTC options. This promises big relief on the pain, operational risk and cost fronts, and importantly offers immediate benefits to the sell-side and corporate/buy-side.
The target is to introduce these services in Q4 2006. Most likely initial participants will be the larger settlement members that are also the major players in these products. Widespread usage, including access for third parties, is likely to occur in early 2007 (though this seems like a long way away, it isn’t). Not all the details are finalised and there is still some work to be done. There are two areas of massive importance that FX business managers ought to get themselves involved in. This applies equally to the sell-side as well as the buy-side.
Firstly, for NDFs, there is the issue of the long-form confirm. CLS can and will offer a matching and settlement service. At the core of the NDF service will be the MT305, which will be used to input the basic economics of the trade to CLS. Over and above this part, a master agreement needs to be in place to cover the terms normally defined in a long form confirm. While, regrettably, there is no such thing in place today, a lot of preparatory work has been done to move towards this. Traditionally master agreements were something that was bilaterally exchanged. This is a lot of paperwork.
In CLS, we have already introduced a ‘better mousetrap’, using the EUREX Repo practice as a model, the community agreed on a ‘join-the-club’ agreement for the participants in in/out swaps. The idea being ‘sign once, join in’ making participation easier than before. When CLS does the rounds to agree the practice, support from FX business managers would help implement a really great low-cost solution. For the corporate treasurers, this will present a great opportunity. Once it exists, they too can sign once and reduce NDF operational processing to some very simple steps.
With its original roll out, CLS did not embrace the buy-side from the outset. Of course, like trying to fit air conditioning into a car once it’s left the factory, getting the buy-side to use something that is up and running is proving to be hard work. For both OTCs and NDFs, there is an opportunity to include a buy-side solution from the outset. Today, for these products there is a huge amount of paperwork, often involving reams of faxes. The sell-side expect the buy-side to review the confirms and send them back. The process is nothing but tedious, long-winded and error prone. Right now, there is no alternative.
How different would life look if there was one central pace where the buy-side could see all their trades from every market counterpart, affirm them, download them to be booked and keep track of any expiries? That would make a real difference. If CLS can provide an access portal for all buy-side shops, they would be able to log in and affirm all the trades with any sell-side shop. Instant nirvana. This is one option; another might be for the third party service providers to do something similar. If you are a sell-side business manager, you should support the cause, be curious and get those who look after CLS to insist that this be part of the design. If you are on the buy-side, talk to those banks you see as potential suppliers of third party services – see what they can do for you and see if they can help shape the future.
If you are not a major market maker pumping through thousands of trades per day, there is more than just fine-tuning to think about. Do you need your current nostro network with a different provider for every currency? You might need direct relationships in USD and EUR, but is it worth the expense of maintaining all the rest? Over time we can also expect the number of banks offering CLS third party services to decline and also that some direct settlement members opt to participate as third parties. If you are using CLS today, are you sure your provider will be offering a full service tomorrow? CLS is still in development so you should expect and demand to be kept well informed.
‘Activist’ can be a positive term as well as a negative one. Everybody in this business needs to remember that there are limits to the amount of efficiency and effectiveness any one institution can draw out of a process. We are destined to interact and cooperate with each other because it takes two to settle a trade. CLS represents an amazing industry utility with enormous potential. That potential will only be achieved when we all get involved, have an opinion and contribute.