By Anindya Bhattacharyya
Settlement risk in foreign exchange trading has cast a shadow over the industry ever since the 1974 failure of Bankhaus Herstatt. But industry participants are increasingly confident that the beast of settlement risk can be laid low by hooking up to the continuous linked settlement system currently being built by CLS Services, a consortium of forex market players dedicated to eliminating settlement risk by ensuring each leg of an FX deal is settled simultaneously.
CLS is a mammoth project involving forex operations experts, technologists, compliance officers and senior business managers at banks. Almost every area of the forex business is in some way affected by CLS, with back office operations acting as the focal point for the impending changes.
Wayne Ferguson, a vice president at Deutsche Bank and spokesperson for CLS Services, says the consortium is currently preparing for member testing, which is scheduled to start in October this year. CLS is also nailing down details of member certification, he adds, including setting standards for operational procedures, business continuity planning and system security.
The member testing phase will include the current CLS beta testers (Barclays Capital, HSBC, JP Morgan and UBS Warburg) and a number of other CLS shareholders, says Ferguson. If successful, member testing will be followed by an operational trial and acceptance, with a go-live date in September 2001. “A number of firms are now making arrangements to be live on the CLS system from day one,” adds Ferguson. “Within a year of the go-live date, CLS Services expects most of its customers to be operational on the system. The majority of those banks will operate as CLS settlement members.”
The consortium plans to use Swift’s new network for communication between CLS Bank and its members. The new network will offer secure and reliable real-time links, operating on either Microsoft Windows NT or Unix networks. Ferguson adds that CLS will be the first implementation of the new facility. “Swift’s new network will allow CLS members to receive information on a real-time basis and to interactively call for specific information, such as trade status or cash positions,” he says. “This will make real-time reconciliation truly possible.”
CLS was originally slated for launch at the end of this year, but this date has now been pushed back nine months to September 2001. The decision to change the launch date was primarily sparked by planning and resources issues, as opposed to technical ones. Indeed, many banks, such as Chase Manhattan, welcomed the news, arguing that the delay gave them much-needed breathing space to ensure their systems and procedures were up to scratch.
Delays such as these are by no means unusual in huge systems projects, of course, but the setback nevertheless raises some concerns. And CLS’s success or failure depends ultimately on confidence: if the system does not rapidly attract a critical mass of trades, it will meet the same fate previous forex settlement risk reduction initiatives, such as the now-defunct Echo multilateral netting system, which has been absorbed by CLS.
The stakes are certainly high. Banks have invested heavily in re-engineering their settlement operations to meet CLS’s requirements. Operations technology vendors have also backed the initiative with cash, developing and marketing solutions that link existing settlement systems to the CLS network. Moreover, the regulators are watching these proceedings closely. The CLS initiative was launched in response to regulatory concerns over the unchecked growth of systemic settlement risk in forex markets. If it fails, the regulators will have to take more direct action, most probably in the form of increased capital charges.
Ferguson is upbeat, however. “The industry is as confident as ever in CLS,” he says. “The G10 central bank governors re-affirmed their support for private sector efforts to reduce forex settlement risk during their meeting of 8 May 2000. As for the shareholders themselves, CLS Services has just completed a very successful refinancing effort and has received additional inquiries from other institutions that are currently considering becoming new members of CLSS.”
Given this near-uniform industry consensus that CLS will become a reality, many banks are now considering what the wider implications of the project will be. One common prediction is the emergence of a two-tier forex market; the top tier comprising settlement members of CLS (ie, large banks) and the bottom tier comprising the rest of the market. The logic behind this prediction is that CLS membership will reduce settlement risk, thus narrowing spreads between the elite players. Those outside this charmed circle will continue to carry settlement risk ‘ and consequently will trade at less attractive bid/offer prices.
This gradient naturally opens up a market opportunity for major banks, namely offering third party CLS access to their customers. Several settlement members of CLS are pursuing this opportunity, including Deutsche, Barclays Capital, ABN Amro and HSBC. Software vendors have also responded to this demand, with companies such as Mpct Solutions developing and marketing systems specifically designed to enable banks to offer third-party CLS services to clients.
Ferguson is more cautious, however. “Many market experts do not believe that a two-tier market will take place,” he says. “Many feel that forex traders will still search the market for best price and availability, rather than concentrate on better pricing due to a reduction in settlement risk. Other considerations include the changes required in electronic dealing systems (Reuters, EBS) to allow for a two-tier market.”
Nevertheless, Ferguson concedes that a two-tier market is a possibility. “If the component of settlement risk is removed from a forex deal, any risk management model would suggest an improved market price. Of course, no one can say for sure until CLS is live,” he says.
Michael Dugard, director of new business at Mpct Solutions, also doubts that a two-tier forex market will appear overnight once CLS goes live. He sees regulatory pressure as the primary driver for institutions to operate through CLS, though he adds that settlement risk may become a factor in deal pricing in the medium or long term.
On the issue of third party services in general, Ferguson notes that only “a handful of CLS Settlement members” have the “size, scale and a number of correspondent bank customers” to offer CLS to third parties. “These services will be popular with those institutions that do not have a particularly large forex presence as to warrant joining CLS directly, or that do not wish to make the IT investments necessary to participate in CLS directly as members,” he says.
Deutsche’s third party CLS offering will allow users to access the system over the Web, says Ferguson. This feature will appeal to firms that aren’t members of Swift members, he adds, such as non-financial corporations. “I anticipate offering this CLS third party service in a similar way as we do correspondent banking today, as a somewhat traditional banking service,” he says.
Mpct Solutions’ CLS Server product also includes Web-based access for end-users, says Dugard. The Mpct system has been selected by Barclays and ABN Amro to support their third party CLS businesses, he adds.
Ultimately, the market will decide whether third party CLS services are a viable business line for banks. But CLS has further operational implications that affect all its members, whether or not they choose to offer third party access. In particular, CLS will entail changes in liquidity management processes, an issue that is currently being tackled by participants in the system.
“As CLS contains a feature of netted settlement, less liquidity will actually be required for settlements ‘ but that liquidity will be required at specific times of the day, for instance within the five-hour timeframe of CLS settlement,” explains Ferguson. That timeframe may be “at an awkward time of day”, he adds. “In the US, dollar liquidity may be needed between 1:00 am and 6:00 am, while in Japan, yen liquidity may be needed between 3:00 pm and 8:00 pm.”
CLS has set up working groups in various locations around the world tasked with developing solutions to the liquidity issue, says Ferguson. “Four possible solutions have been identified and already one of them ‘ the in/out swap ‘ seems to be gaining consensus. Our global treasury management team has suggested this potential solution to the European Central Bank working group discussion on CLS liquidity,” he says.