With CLS now live, you can almost hear the collective sigh of relief uttered by those in certain foreign exchange and technology circles, which now have a system in place that is designed to mitigate settlement risk. As usage increases, the settlement banks are now looking at ways of extending their services to third party banks.
Magnus Allan reveals how they intend to differentiate themselves.
Having launched on September 9 after two years of delays, Continuous Linked Settlement (CLS) is now a reality among a select few institutions. Already, CLS is beginning to live up to its promise: to eliminate FX settlement (or Herstatt) risk by centrally netting FX payments between counterparties using a central clearing house (CLS Bank). But now that it is live, its 67 shareholders face questions about the future, and how to extend the service outward.
In keeping with CLS’s chief executive officer Joseph De Feo’s measured approach (see Profit & Loss, September 2002), the banks taking part in the first wave began trading with a half-dozen partners, which have since doubled as part of the controlled unscripted live phase (CULP). During CULP, the participating groups will be handling unscripted live instructions in seven currencies (US dollar, euro, sterling, yen, Swiss franc, Canadian dollar and Australian dollar), initially in limited groups to ensure that the system is fully bedded in before full and free interaction commences. Gradually, the groups will be brought together over the next few months until all the shareholders are operating within a single pool of liquidity (see Profit & Loss, July/August 2002).
In its first few weeks of life, confidence is already building. During the second week of operation, 24,000 sides (or 12,000 trades) were completed, with $300 billion of gross value traded during the first fortnight, this rose to $1 billion by the end of September, and by mid-October, 10,000 trades (with a value of $100 billion) were going through the system on a daily basis. Full unrestricted trading between all the banks involved began the week of October 14, a step CLS hopes will lead to an increase in daily value to $300 billion.
A few hiccups have been reported, but nothing that hasn’t been resolved. “There have been some incidents with the individual payment arms, but they have done very well to deal with these issues as they have arisen,” says Olaf Ransome, director and head of CLS for Credit Suisse First Boston (CSFB). “There has been some downtime and delays, but we have not gone beyond the end of a trading day. People have dealt well with the problems and the fallback scenarios have worked very well. As someone put it, day to day operations are reassuringly boring, which is what operations managers want. They do not want drama.”
However, drama played a large part of CLS’s early days, having missed two successive years of launch plans. For some, these delays stand out as an opportunity missed. “We were pretty early to market in thinking about CLS third party services, and we had a very clear idea of what we wanted to offer customers early on,” says Karin Flinspach, European head of fund transactions, liquidity management and clearing services at Citibank. “So it was a big disappointment for us when the system was delayed, which also let the competition catch up and create similar product offerings.”
But since launch, market sentiment has understandably turned upbeat. “We have seen hundreds of our FX trades settling through the system daily within our group, and the process has been functioning very smoothly,” says Wayne Ferguson, vice president of Deutsche Bank Global Cash Management (GCM). “Trade permissioning, exception processing and the pay-in schedules have all been operating properly and we have participated in a number of in/out swaps. These have now begun to prove in practice their effectiveness in facilitating intraday liquidity management.” (see side bar).
Third Party Services
As the system beds down and its processes become second nature, thoughts are turning to the provision of third party services, due to go live on November 4. Such services are intended to enable banks outside CLS (ie, non-settlement members and shareholders), or CLS members not active in a particular currency, to take advantage of settlement risk reduction by carrying out transactions with a settlement member.
Third party services are fairly standard across institutions, although differences are beginning to emerge. “The idea is that today, someone who is buying services from seven different banks, can now come to a settlement member and get them to settle all of their trades,” says Ransome. “At this basic level, the offering is fundamentally the same for the approximately 12 banks that have an offering of this sort, and of these there is a hard core of probably six of the usual suspects who are pushing their services. The variations come from how this is handled, and there are some quite big differences in this respect.”
Citi’s Flinspach agrees, adding, “It is not the core CLS access and processing we offer that is so attractive to our customers, because is not much differentiation between the settlement members’ offerings.. It is through the reporting tools, data flows and liquidity management that we provide customers that has proved much more relevant to their needs.
“Being the largest FX bank means the likelihood of banks doing a fair amount of trades with Citibank is also high; so they can be included in the whole process of foreign exchange settlement. As a result, they can either send their trades to CLS or we can put their trades through our books, which is cheaper,” she continues.
“It is quite a task for these third party banks to manage these seven currencies and make sure that funding and credit lines are available,” Flinspach says. “As a result, the more currencies a client keeps with us, the more liquidity-friendly it becomes for them.”
While some are banking on traditional services, others are approaching third party offerings from a different angle. Ransome explains that there is a geographical split in how CSFB is offering its service. “The Swiss banks are taking a very private banking, multi-currency approach, whereby a client that has a number of accounts in different currencies can operate from a single limit,” he says. “Whereas other organisations treat a client as though they have seven distinct pots of money that should not meet up.
“One of our key differentials is the multi-currency handling, so we are able to take some of the complexity out of CLS,” he says. “If we cannot remove the complexity, then we have not got much of a service offering. What you are seeing in some cases is banks saying to third parties, ‘This is part of this agreement…and this is part of that agreement…’ What we are saying is, ‘We will give you a single multi-currency limit, settle all of your trades for you, and when you want to move your cash around, we will do it for you.’”
Is Bigger Better?
To leverage off its market position, Citibank has analysed its client demographic and tailored its offering to match. “We offer fourth party services, which we do not believe are available from any other bank at this stage,” says Flinspach. “Our target market is limited to a few key institutions in every country, so we have developed our service for customers who have a different target market, and which is not in direct competition with Citibank. It enables them to avoid the cost of developing the service for their clients themselves.
“A further benefit for our third party banks that decide to take this approach is that fourth party banks can settle their trades with them and ultimately through us,” she adds. “It is all managed separately so you get separate paying in schedules, separate reports and you can put different controls on the services, so it is all segregated, but at the top it is all settled together.”
Meanwhile, Deutsche GCM is offering a third party CLS service that it was initially very keen to make end-to-end. According to Ferguson, “The client can execute their trades, see their profit/loss, and we have a methodology to do the trade input, confirmation, matching and netting. We can also provide cash projections and settlement tools along with interactive information offered throughout the day, as well as cash and end of day statements and internal reconciliation.
“While we will be charging a small fee per transaction, we place a strong emphasis on bolstering the suite of products that we are able to offer our customers,” he says. “We believe that it is very important to be a multi-product provider, and we hope that our third party services will further strengthen our relationships with clients by offering them a full suite of products.”
As Swift as You Like
In addition to services, a number of institutions are keen to stress that they offer their services through their Web-based platforms, as well as accept Swift format communications. “Our third party service is available via Swift and the Internet, and we have clients looking to use either and both,” says Ferguson. “We believe that we have a compelling product that offers full end-to-end service.”
“What we are discovering is that most of our third party clients want to submit their trade activity via Swift and receive back their data via the Web,” says a source close t the industry. “Swift is very good as a one trade at a time tool, but if you are looking at a portfolio to see all of your unfinished trades or all the trades that have been matched with a counterparty, it may be more effectively carried out via a Web-based tool. “
“The CLS system is smart enough to give trades a lifecycle, but the bad news is that there are several updates for each trade,” notes Ransome. “As a result, it gets costly to do this over Swift, so we give clients a browser and let them monitor trades through that.”
“We said from the beginning that we wanted to be able to offer our CLS services as a Web-based tool which would be linked to our online CitiDirect Online Banking platform, making it very convenient for existing customers to use the services,” adds Flinspach. “Using our system, customers can access us end to end, or they can submit trades to us via Swift and just manage the reporting with the online tool. The user friendliness and the sophistication of the system are high because we have been working on it for a long time.”
Always Straight Through
CLS members are now looking at ways of expanding its benefits beyond banks and even foreign exchange. Preliminary talks are already said to be taking place to determine the feasibility of including securities or money market products – the logic being that if a product uses standard fields, it should not take too much extra effort to include it on the CLS system.
However, before adding other products, CLS is looking at leveraging existing third party services for those such as broker-dealers, corporates, fund managers, custodial banks and investment managers.
But some believe it will take more than promises of risk reduction to get third parties, such as large corporates with just a few FX deals per day, to take an interest in CLS. “If CLS keeps developing and comes up with fantastic straight-through processing benefits, they may well take CLS on the back of it, but they are less likely to take the current proposition,” says Ransome.
Future development promises to keep industry watchers busy for a long time to come. “Offering third party services to clients is a very different proposition from the old correspondent banking, where you were pitching in your local market,” Ransome says. “For us, it is like coming from the top league of a national soccer division and moving into the European Champions League. In many ways it is a great deal more challenging, but at the same time, it is a lot of fun.
“It is quite similar to what happened in custody where, years ago, people would buy custody in every country. But the market evolved and people in Switzerland moved to using SIS SEGA Intersettle, and let it manage the network,” he reflects. “Yes, it may have meant a little more cost per transaction, but they no longer needed to deal with connectivity issues or be experts in all countries. You can see this happening as a result of CLS among the third parties.”
FX Around the Clock
The inside/outside swap (I/O) is one of the key tools CLS is using to meet off-hours liquidity demands. The I/O swap comprises two equal and opposite FX spot trades, struck at the same rate in the same currencies between the same two counterparties. The only difference between the two legs is that one settles inside CLS while the other settles through normal channels.
So, by using I/O swaps, currencies that are traded outside the European time zone but need to be settled between 0700 and 1200 CET, can do so. I/O swaps are not used to entirely close out CLS positions, but only to bring them in line with predefined short position limits. CLS identifies the various counterparties with offsetting positions inside CLS and determines appropriate swap transactions and partners. Post-swap positions inside CLS are within the defined short position limits for each settlement member, easing the potentially large liquidity demands during the pay-in cycle. Settlement of the reversing leg of the swap occurs through the course of the normal settlement day for each location and currency.
While the use of I/O swaps is generally acknowledged as the most efficient way of meeting the demands for global, round the clock settlement in CLS, some argue that their use does not sit well with the CLS concept. “It is interesting because the whole purpose of CLS is to eliminate FX settlement risk, so using I/O swaps reintroduces an element of settlement risk as well as adding some liquidity risk,” says Bruce Mathrick, executive treasurer at ANZ Banking Group in Melbourne.
Mathrick points out that while I/O swaps are not perfect, they are the best tool available at the present time to ensure the inclusion of currencies outside European trading hours and, most importantly, the level of risk is still lower than existed prior to the introduction of CLS. The bank’s modelling suggests that as little as 2-3% of settlement risk is re-introduced through the use of I/O swaps.
For ANZ’s operation in its home territory, the introduction of CLS has meant only a little extra work compared to colleagues in the Northern Hemisphere. “We have simply had to extend working shifts out to 10:00 pm,” says Mathrick. “Assuming that the number of currencies is extended to include the New Zealand dollar,contemplated for 2004, we will simply have to extend the desk’s hours to midnight in New Zealand. The idea of CLS is a good one, but only time will tell whether it will be worth the cost.”
ABN AMRO Bank
Australia and New Zealand Banking Group
Banco Bilbao Vizcaya Argentaria
Banco Popular Espanol
Bank of America
Bank of Montreal
Bank of New York
Bank of Nova Scotia
Bank of Tokyo-Mitsubishi
Bear, Stearns & Co.
Commonwealth Bank of Australia
Credit Agricole S.A.
Credit Suisse First Boston
Den norske Bank
Development Bank of Singapore
Dexia Banque Internationale a Luxembourg
Goldman Sachs Group
JPMorgan Chase Bank
Mizuho Corporate Bank
Morgan Stanley & Co
National Australia Bank
Northern Trust Corporation
Oversea-Chinese Banking Corporation
Royal Bank of Canada
Royal Bank of Scotland
Skandinaviska Enskilda Banken
Standard Chartered Bank
State Street Bank and Trust Co.
Sumitomo Mitsui Banking Corporation
Sumitomo Trust & Banking Co.,Ltd. Japan
United Overseas Bank
Westpac Banking Corporation
*Shareholders as listed on CLS website