CLS: Riding Out the Credit Crisis
There has never been a better time for financial institutions to seek out the stability and efficiency of systems designed to mitigate the risks of participating in global payments. Lehman Brothers’ shocking collapse last year, and the financial industry’s subsequent plunge into a global credit crisis, underscores the reality that systemic risk looms large with the settlement of complex financial transactions. Fuelling the situation is the growing number of asset classes that have become part of the trading mix, and with them the complexity and risk of ever-increasing settlement schemes.
In 2002, continuous linked settlements (CLS) were introduced by a group of large financial institutions from around the world through CLS Bank. Nearly 60 financial institutions now hold an account with CLS, enabling them to execute transactions for themselves and on behalf of nearly 5,500 third party customers. CLS is behind approximately 55% of all foreign exchange (FX) transactions conducted worldwide. At its peak volume, CLS settled more than 1.5 million transactions in a single day last September. The peak value it settled during a single day reached US$10.34 trillion in March 2008.
CLS is continuously growing. It currently settles 17 currencies, up from seven when it first started. In recent years, it has expanded to support trading categories beyond FX, including non-deliverable forwards (NDFs) and over-the-counter (OTC) credit derivatives. Increasingly, it is gaining clout as the worldwide standard for executing payments in the global arena.
Today, CLS has become a settlement service that is the industry standard for handling FX; and is a model for other traded financial products that require complex bilateral and multilateral continuous settlement schemes. CLS proved its ability to reduce settlement risk during the demise of Lehman by providing transparency and trading confidence throughout the ordeal. It aims to continue to be relevant by expanding its ability to handle the growing number of trade-related instruments.
For this reason, it is imperative that a CLS back-office solution be highly configurable. A rules-based system can quickly and efficiently handle new asset classes with minimal code changes. Workflow management, settlement rules, and operational reporting conducted by the CLS back office must balance CLS policy and bank policy – these must be built into the bank’s CLS solution.
The biggest testament to the success of CLS is seen in its performance during the Lehman crisis. CLS was created specifically to prevent cross-currency settlement risk (also known as Herstatt risk, after the German bank whose failure in June 1974 led to massive FX trading losses at its counterparties). Because of the stability and transparency CLS provided, Lehman’s failure did not severely disrupt the market, as was the case with Herstatt Bank. CLS had done its job. The European Central Bank, in a March 2009 report analysing the operational lessons from Lehman’s demise, found that, “At the end of the day, CLS proved that it effectively offsets the problems it was designed for, i.e. to prevent a systemic crash by removing principal risk (the so-called Herstatt risk).” The report further concluded: “The Lehman downfall proved that CLS is an effective measure to mitigate settlement risk.”
But CLS Bank by itself could not have achieved this success without a robust network of back-office applications that provide the processing backbone and ‘enforcer’ of the CLS processing model. Banks with a solid CLS back-office solution can manage crisis scenarios gracefully, enabled by strong straight-through processing (STP) capabilities.
For banks that provided CLS third-party services, the need for a sophisticated CLS back-office application has proven to be critical. With its cascaded settlement model, a settlement member’s ability to effectively process trades with CLS Bank is intertwined with its third-party settlement business. Banks that have the ability to replicate the CLS settlement model in their own back office are almost guaranteed to manage the risk in a consistent and transparent way.
Some large banks may have almost three times more exposure to settlement risk than to credit risk. And in the FX market, transactions can involve daily settlement exposures of tens of billions of dollars to individual counterparties. CLS focuses specifically on easing the pitfalls of settlement, a risk category facing increased scrutiny, given the current economic climate. CLS’ proven ability to reduce the risks of global payments has generated increased interest in the service by banks around the world.
CLS addresses settlement risk through a payment versus payment (PVP) process. Each of the two parties to an FX trade pays out one currency and receives another simultaneously, thus avoiding the possibility that an institution pays out funds without receiving reciprocal funds due. In effect, CLS eliminates settlement risk in FX, the world’s single largest financial market. It is still the responsibility of the settlement member’s treasury to manage the settlement risk with its third parties. Only a sophisticated CLS back-office system can provide settlement risk management between the settlement member and its third party that is on par with the CLS settlement risk management infrastructure.
In addition to removing settlement risk, CLS offers a number of operational and liquidity benefits, leading to significant cost savings. For example, CLS members base their daily funding requirements on a multilateral net position, rather than gross transaction-by-transaction funding, which reduces necessary daily funding by 95%. Accordingly, CLS members have to fund less than US$50bn a day for every US$1 trillion of value settled. CLS members also enjoy the benefits of STP, lowered payment volumes and fewer failed settlements. Similar benefits can be offered by a settlement member to its third parties through their CLS back-office solutions. A comprehensive CLS back office will offer service level agreements (SLAs) with several payment schedules and funding options that can dynamically execute best practice STP rules that meet the needed risk profile of a particular CLS third party.
As CLS continues to ascend to a dominant position in the FX market, financial institutions should be aware of the many ways they can use CLS to enhance their own businesses.
Financial institutions that choose to become settlement members of CLS have the opportunity, in turn, to offer CLS settlement services to other institutions on a third-party basis. That opportunity is becoming more pronounced as the volumes and number of products traded through CLS continues to grow. Through the CLS process, banks will be required to open new Nostro accounts for their CLS Business and this acts as a natural entrée to earning increased cash management and treasury business from third-party customers.
As well as the clear advantages of the elimination of settlement risk, CLS provides operational oversight and controls throughout the transaction life cycle, bringing consistency and efficiency to the risk management process. It is also very important to consider the risk controls required in providing third-party services. Standard practice here would be to use a vendor product as internal FX applications will not have the capabilities to monitor and calculate the risk of these trades. Risk controls should be in place to check the trades prior to entry into CLS and also the payments to the third parties on settlement day.
Membership in CLS helps ensure compliance with the Basel II Committee guidance for managing settlement risk in FX transactions. In addition, CLS’s built-in operational controls assist institutions in achieving compliance with Sarbanes-Oxley (SOX) and equivalent legislation.
As buy-side and sell-side firms, together with fund managers and their banks, become part of CLS, the methodology and routines associated with the service will become increasingly accepted throughout the world. This will strengthen global practices and foster trust between all participants.
CLS’s same-day funding cycle greatly reduces the cash outlays required to complete settlements. In addition, multilateral netting reduces the number and amount of payments that must be made. As settlement is virtually guaranteed, this gives treasury groups earlier notification and confidence with their intra-day credit lines. The end-of-day reconciliation process for the bank’s trades also becomes more efficient as they are no longer reliant on an individual payment to settle a single trade.
Central banks around the world are staunch advocates for participation in CLS. Financial institutions that become settlement members help support common global goals that contribute to financial stability.
CLS will naturally streamline the banks back-office processes, which in the end will lead to cost savings in this area. Through experience it has been found that supporting day-to-day CLS operations is an extremely efficient process and will not require any additional resources. By utilising specific CLS messaging criteria banks will see STP rates increase, error rates and resulting interest claims will reduce to zero, resulting in savings in resources and costs in these areas. As the CLS market continues to grow to include greater volume and product, it can be safely assumed these efficiencies will continue to grow with it.
CLS settlement members can take advantage of automated trade processing for instruments that traditionally have involved labour-intensive routines. The bank-driven move of CLS into the settlement of NDF trades is a clear example of this. Settlement membership of CLS will ensure a voice and a seat at the table within CLS, ensuring a bank can steer the community towards areas of concern that can see potential further benefits. The move into the credit derivative market and partnership with DTCC is a slightly different proposition. Here, another industry crying out for a secure settlement service is able to utilise the infrastructure already successfully established by CLS. Such ventures only increase the exposure of CLS and others will surely follow.
The best way to take advantage of all the benefits CLS has to offer is through a dedicated back-office CLS system that is optimised to fully exploit its capabilities. Sophisticated vendor products installed in-house to connect to CLS let institutions use liquidity and other tools available through CLS to engage in cutting-edge strategies to better understand and manage their positions.
In selecting a vendor product, banks will also gain greatly in the implementation expertise of their new partner for their CLS project. They immediately gain the insights and knowledge acquired during the experiences of other CLS projects. This gives the bank confidence it will be entering into CLS operations in the most efficient and cost-effective manner, free from the pitfalls that could take place without engaging with such expertise.
CLS’s success in eliminating risk, particularly through turbulent times, assures its continued growth. There is no doubt that institutions around the globe will increasingly look to CLS to bring stability and confidence to settlement in the FX market. Institutions that have not yet aligned themselves with CLS should begin plotting their strategies to do so now.