Cash & Liquidity ManagementInvestment & FundingEconomyOptimising FX Settlement Risk: CLS and Beyond

Optimising FX Settlement Risk: CLS and Beyond

Foreign exchange (FX) settlement risk – the risk of a bank in a foreign exchange transaction paying the currency it sold without receiving the currency it bought – is one of the biggest concerns in today’s international banking community. As the FX market continues its trend of exponential growth year on year and average daily trade volumes today exceed US$3 trillion, it’s not surprising that FX settlement risk has dominated the G10 governors’ agenda for over 10 years.

FX settlement failures can arise for a number of reasons: counterparty default, operational problems and market liquidity constraints are just a few examples. Settlement risk is inherent in any trade activity, but it is the size of the foreign exchange market that makes FX settlement risk such an important issue – for many banks, FX transactions are the greatest source of settlement risk exposure. In some cases, large banks have almost three times more exposure to settlement risk than to credit risk.

Improving Settlement: RTGS and CLS

Settlement risk has historically been a problem in foreign exchange markets because, due to time zone differences, several hours might elapse between a payment being made in one currency and the offsetting payment being made in another currency. The introduction of real-time gross settlement (RTGS) has eliminated some of these risks by providing real-time settlement. But challenges remain as speed and real time transactions become more important in all areas of finance, including FX transactions.

The introduction of continuous linked settlement (CLS) in 2002 changed everything in terms of FX settlement risk. CLS is a real time, global settlement process that eliminates settlement risk caused by foreign exchange transactions occurring across different time zones.

Essentially a ‘banker’s bank’ for FX settlement, CLS settles foreign exchange flows between some of the world’s largest banks along with their customers and other third-party participants. Both sides of the FX transaction are settled simultaneously on a payment versus payment (PvP) basis, ensuring that all payments and receipts for an FX trade occur simultaneously, eliminating settlement risk.

On average, CLS netting efficiency is in the region of 98%. As a result, it has rapidly become the market-standard for foreign exchange settlement between major banks, settling approximately 400,000 instructions a day in 15 currencies. This represents 55% of global FX trading.

Settlement Alternatives – Bilateral Netting

So what about the other 45% of the trades that don’t flow through CLS? One alternative is bilateral netting – a legally enforceable arrangement between a bank and counterparty.

While multilateral netting models – such as the one used by CLS – typically involve multiple parties mediated by a clearing house or central exchange, bilateral netting only takes place between two parties. In bilateral netting, banks must agree and draw up a contract to define which transactions are included in the agreement. The net worth of all transactions carried out in a single currency within a defined period can then be settled in a single payment. This helps reduce both risk and the cost of clearing.

Cash transactions are still the majority, but an increasing number of derivative transactions are bilaterally netted in today’s environment. Bilateral netting currently accounts for about US$1 trillion of trades daily.

Banks are also involved in bilateral agreements that cover cross product and cross structure netting. As banks continue to expand their bilateral settlement agreements on a currency/product basis, third-party software vendors are developing tools to identify potential netters and even auto-netting facilities to assist in this regard.

A number of pre-payment netting solutions have recently been launched. Some of these work by receiving deals from the various dealing platforms and determine whether or not each deal is netting-eligible based on customer-defined parameters. Before netting, trades are matched by the system to ensure netted trades do not have to be reopened. Banks can data-manage daily trade positions and aggregate them to find their net exposure. This is then processed by the back office. While these solutions certainly offer added value to their bank clients, their value with regards to CLS is limited because CLS currently only accepts deal tickets. They do not accept these netted deals as payment records.

The introduction of CLS in 2002 changed the landscape in terms of FX settlement risk. Its PvP model virtually eliminated FX settlement risk for all trades passing through the system. Unfortunately, CLS still only settles 55% of all FX trades globally. For the other 45% that don’t pass through CLS, FX settlement risk is real and banks must find alternative solutions.

Bilateral netting seems poised to fill in the void for trades that settle outside of CLS. It currently accounts for over US$1 trillion of trades daily already and helps to reduce both settlement risk and clearing costs.

While there are a number of third-party vendors who have recently launched bilateral netting solutions, it will, in the end, be the banks that drive the development in this area. Third-party vendors will still be involved, but they must be prepared to follow the lead of these banks.

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