CLS Bank was introduced to address foreign exchange settlement risk in the interbank market,but its risk-reduction and netting benefits could find wider application among corporate treasurers and fund managers.
The specter of foreign exchange settlement risk has preoccupied the international banking community since the collapse of Germanys Bankhaus Herstatt in 1974. More than two decades later the publication of the seminal Orange Book highlighted the two- to three-day time lag between settling both legs of an FX transaction and called on the international banking community to individually and collectively address interbank FX settlement risk. In that time global daily FX market turnover has reached $3 trillion, demonstrating the potential fallout if a trading counterpart were to renege on a deal.
On September 9, 2002, CLS Bank, the industrys answer to Herstatt risk, went live with 39 settlement members (an additional 16 banks have since been approved) and representation among shareholder banks constituting 80% of the worlds FX business by value. CLS Bank holds accounts with central banks in each of the seven currencies (Australian dollars, Canadian dollars, euros, Japanese yen, Swiss francs, US dollars and UK sterling) it settles. Settlement members must pre-fund their CLS short positions within a short settlement window (9am CET). Both legs of an FX transaction are settled across the books of the bank simultaneously in what is known as payment-versus-payment (PVP) settlement. CLS Bank currently settles on average 70,000 payment instructions per day, with a gross value of $800 billion. TowerGroup estimates that by mid-2005 176,000 settlement instructions per day will be settled by CLS Bank.
If CLS becomes the standard settlement mechanism for FX, the next logical step is that a significant majority of FX trades, including those in the securities and corporate treasury market, could migrate to CLS. In an effort to establish new sources of business revenue, settlement members are proactively marketing third-party CLS services to their customers, including financial institutions, corporates and fund managers. These are institutions that do not have the transaction processing capabilities or desire to become direct participants in CLS but that wish to harness its risk-reduction benefits. Third-party customers went live within CLS late last year.
Michael Knorr, global product manager,
Citibank CLS Settlement Services
Third parties are the most promising area in terms of adding volumes within CLS, says Arthur Howlin of City Networks, which provides technological solutions for CLS third parties and banks. At Sibos in Geneva last year, Rob Close, chief operating officer of CLS Group Holdings, announced its goal was to settle 500,000 sides a daythe bulk of which will presumably come from third-party business. Uptake of third-party services so far has been slow, but once additional currencies such as the Hong Kong dollar and Singapore dollar come online later this year, banks anticipate renewed interest from prospective CLS third parties. Bernard Valvona, senior manager, transaction sales and financial institutions, for Standard Chartered Bank, says since CLSs successful launch, customers in emerging markets had taken a more proactive stance toward the FX settlement bank. Interest has been generated by their ability to see the system up and running and operating successfully, he says.
Settlement members are getting the third-party component on board as fast as they can, observes Jonathan Butterfield, executive vice president, marketing and communications, CLS Bank International. He says some settlement members were still focused on consolidating regional FX processing among their own branches, which could take some months. The automation and operational procedures are quite significant, he states. We [CLS] are re-engineering the industry to some extent.
Paul Imm, product manager CLS, JPMorgan Chase, reports a steady increase of 13% a month among institutions expressing an interest in CLS third-party services. To date, 66 institutions have signed up as CLS third parties, including brokerage and investment houses such as Bear Stearns Securities, Cantor Fitzgerald and Winterthur Life & Pensions. Although the majority of interest in third-party services is from banks, settlement members and CLS Bank are increasingly focusing their attention on corporates and the fund management community as prospective customers.
In the corporate world, the issue is not so much one of risk reduction, but the benefits CLS offers in terms of centralized cash and liquidity management. Any large corporate that has an active FX trading desk hedging its receivables and payables would potentially be interested in the risk-reduction and liquidity benefits CLS offers, says Peter James, a senior analyst with TowerGroup.
The Bank of New York has experienced interest from corporates with sizable treasury operations and expects to see the same from fund managers. CLS reduces internal FX lines by 50%, while increasing trading, says Joe Furnari, head of international cash management sales at The Bank of New York. Once third parties realize the benefits, we will see demand increase. Deutsche Bank is specifically targeting insurance companies and manufacturers looking to manage their FX exposures in terms of large foreign currency payroll and account payable and receivable. CLS is too important to restrict it to 50 or so settlement members, says Wayne Ferguson, vice president, global cash management, Deutsche Bank. The more people that participate in CLS, the greater the benefit for everybody.
Certainty of settlement and the ability to more-accurately forecast cash flows makes CLS an interesting proposition for corporate treasurers. CLS brings certainty of receipt of cash from FX trading, which minimizes settlement failures
Joseph De Feo, CLS Group chief executive officer
and in turn means less back-office investigation costs, explains Imm of JPMorgan Chase. Payments are funded on a net basis within CLS, eliminating the need for corporate treasurers to move large sums of money unnecessarily between subsidiaries. The netting effect within CLS is 95%. The multilateral netting effect corporates can get from CLS will minimize daylight overdraft utilization, observes Michael Knorr, global product manager, Citibank CLS Settlement Services.
And as the predictability of cash flows increases, so does treasurers ability to better manage liquidity, which might otherwise sit idle in accounts held by other subsidiaries. Increasingly, settlement member banks are selling CLS as an integrated part of their corporate cash management offering. CLS is a cash management tool, says Joerg Pinkernell, head of global business management, FI services, at ABN AMRO Bank, which recently signed a major US corporate as a third-party customer. You can consolidate information, consolidate liquidity and cash flows.
Enhanced Risk Management
CLS is also finding a role in the custody market. CLS Group chief executive officer Joseph De Feo has raised the possibility that in the future, as pension funds come under increasing pressure to reduce risk and custodians struggle under the weight of inefficient paper processes, CLS could become the P in delivery-versus-payment (DVP) securities settlement. DVP and T+1 in the securities markets hinges on the ability to settle the security and associated foreign exchange leg of a transaction simultaneously. According to BIS figures, 20% of the value exchanged in FX is securities-related. Butterfield says CLS has already completed a lot of the work needed in terms of harmonization across different interest groups to agree on an identification standard for it to capture a significant portion of securities-related FX business.
A custody working group comprising banks and fund managers has agreed on a common fund ID code that will facilitate the matching of investment fund FX settlement instructions in CLS. For individual funds there was no global referencing system in existence, Butterfield explains. However, the working group has agreed that the fund ID will be used to link the counterpart to the fund for matching purposes within CLS. Custodians that are settlement members of CLS will implement the change in the fourth quarter this year. CLS is important in helping the move to T+1, says John Rowland, third-party product manager, JPMorgan Chase. Under current practices, if you are trying to fund a securities transaction, it is not known for a couple of days whether the funds are available or not. With CLS you will know pretty much by the start of the day.