optimizing settlement risk management - cls and beyond

7/27/2019 Optimizing Settlement Risk Management - CLS and Beyond

1/12

Optimizing settlement

risk management:

Cls and beyOnd

A Wh Pap Wa S Sss


2/12 www.wallstreetsystems.com

OPtimizing Settlement riSk m AnAgement: ClS And beyOnd

COntents

ioco 3

ClS: so h s s co 4

th hso o FX s s5

th Hsa ic 5

th oao a sfcac o ClS 5

th ClS pocss a s c o FX a 6

th c o a chas ac

ClS as 6

Aas o ClS 8

baa 8

Sa-a o x-a s 9

A ss o h 9

Cocso 10


3/12www.wallstreetsystems.com

OPtimizing Settlement riSk mAnAgement: ClS And beyOnd

Foreign exchange (FX) settlement risk

the risk o a bank in a oreign exchange

transaction paying the currency it sold

without receiving the currency it bought

is one o the biggest concerns in todays

international banking community. As the

FX market continues its trend o exponential

growth year on year and average daily

trade volumes today exceed $US3 trillion,

its not surprising that FX settlement risk has

dominated the G10 Governors agenda

or over ten years.

FX settlement ailures can arise or a

number o reasons: counterparty deault,

operational problems and market liquidityconstraints are just a ew examples.

Settlement risk is inherent in any trade

activity, but it is the size o the oreign

exchange market that makes FX settlement

risk such an important issue or many

banks, FX transactions are the greatest

source o settlement risk exposure. In some

cases, large banks have almost three times

more exposure to settlement risk than to

credit risk. The sums o money involved arehuge FX transactions can involve credit

exposures amounting to tens o billions

o dollars each day, and in some cases,

exposures to a single counterparty are

in excess o an institutions capital.

Settlement risk has historically been a

problem in oreign exchange markets

because, due to time zone dierences,

several hours might elapse between a

payment being made in one currency

and the osetting payment being made

in another currency. The introduction o

Real Time Gross Settlement (RTGS) has

eliminated some o these risks by providing

real-time settlement. But challenges remain

as speed and real time transactions

become more and more important

in all areas o nance, including

FX transactions.

intrOdUCtiOn




ClS: SOlving tHe Settlement riSk COnundrum

Continuous Linked Settlement (CLS) is a real time, global settlement process that reducessettlement risk caused by oreign exchange transactions occurring across dierent time

zones. With CLS, both sides o the FX transaction are settled simultaneouslysignicantly

reducing settlement risk in the FX market.

CLS is essentially a Bankers Bank or FX settlement. It began operations in September

2002 with the purpose o settling oreign exchange fows between some o the worlds

largest banks along with their customers and other third-party participants.

With CLS, both sides o the FX transaction are settled simultaneously on a payment versus

payment (PVP) basis. This ensures that all payments and receipts or an FX trade occursimultaneously, eliminating settlement risk.

On average, CLS netting eciency is in the region o 98%. As a result, it has rapidly

become the market-standard or oreign exchange settlement between major banks, settling

approximately 400,000 instructions a day in 15 currencies. This represents 55% o global

FX trading.

Despite this high success rate, CLS has some disadvantages. Membership ees are high,

and the service is relatively expensive on a cost-per-trade basis. Lowering this cost-per-trade

remains a high priority or many CLS users. And while CLS settles over hal o the total FX

obligations worldwide, banks must still nd alternatives or the remaining 45%.

Furthermore, banks ace capacity issues because the volume o tickets being processed

is rising aster than the total notional dollars being traded. Additionally, the high cost o

processing these trade tickets is having a negative eect on margins. As trade volumes

continue their steady increase, it has never been more important or banks to develop a

fexible, adaptable trade-processing inrastructure that will help them to reap the greatest

prot rom their FX trading activity.




tHe HiStOry OF FX Settlement riSkThe oreign exchange (FX) market as we know it today emerged

in 1971 ollowing the collapse o the Bretton Woods agreement

a system o international monetary management established

ollowing the Second World War. The new system or currency

exchange brought with it the hazard o cross-currency

settlement risk. Any bank purchasing currency immediately

risks the ull amount o currency purchased rom the time that

the payment instruction is conrmed and can no longer be

cancelled unilaterally, until the time the currency purchased is

received and the transaction is nal. Although FX settlement risk

was immediately recognized and understood, its eects were

not ully appreciated until 1974.

The Herstatt Incident

On 26 June 1974, the banking license o a German bank,

Bankhaus Herstatt, was withdrawn by local regulators.

Although the bank was relatively small, its collapse had

global implications because o the losses suered by its FXcounterparties. It was ordered into liquidation during the

banking day, but ater the close o the German interbank

payments system at 15:30 local time. Some o Herstatt Banks

counterparties had paid Deutschmarks to the bank, believing

they would receive US dollars later the same day in New York.

But when the banking business was terminated, it was only

10:30 am in New York. The New York correspondent bank

suspended all outgoing US dollar payments rom Herstatts

account; leaving its counterparties ully exposed to the value

o the Deutschmarks they had paid the German bank earlierin the day.

The Herstatt case brought the issue o settlement risk to

the attention o the international nance community, but

unortunately it was not the last incident o its kind. More recent

examples o what is sometimes still reerred to as Herstatt Risk

include the collapse o Drexel Burnham Lambert in 1990, the

all o Bank o Credit Commerce International in 1991 and

the collapse o Barings Bank in 1995, all o which had global

implications related to FX settlement risk.

Over the years, FX settlement risk has provoked intensive

study and research, including:

The 1989 Angell Report on Netting Schemes

Noels 1993 Central Bank Payment and Settlement Services

with respect to Cross-Border and Multi-Currency Transactions

The 1996 Allsopp Report entitled Sett lement Risk in Foreign

Exchange Transactions

In 1996, a study by the G10 central banks ound that banks

oreign exchange settlement exposures to their counterparties

were in many cases extremely large relative to their capital,

lasted overnight or longer, and were poorly understood and

controlled. To try and resolve these issues, the G10 launched

a high-prole project to tackle the issue o FX settlement risk

by devising a strategy to improve the understanding and

management o settlement risk, as well as reduce the systemic

risk arising rom the settlement o oreign exchange trades.

The ormation and signifcance o CLS

Following the 1996 study, the G10 member banks agreed to

the continuous linked settlement concept, which allowed or

the simultaneous exchange o currencies and thus eliminated

settlement risk. In 1997, the banks launched CLS Services, a

private, not-or-prot group owned by major trading banks and

brokers, with the aim o developing a specialist bank to handle

settlement processing. CLS Bank was launched ve years later

and is based in New York. It settles oreign exchange fows or

CLS members, their customers, and other third parties.

Over the past ve years, CLS Bank has had a wide and positive

eect on the FX trading community. It has completely eliminated

settlement risk on the FX trades it processes.




tHe ClS PrOCeSS And itS eFFeCt On FX trAding

CLS ollows a well-dened set o processes. A single multi-currency account is created oreach settlement member. Accounts are credited when unding pay-in occurs and debited

when unding pays out. Each member has its own account with CLS Bank rom which it

sends and receives currency payments. Members submit their instructions details o

payments in specied currencies to CLS on a daily basis. Beore daily settlement

commences, CLS provides the net cash position to each member and ensures that all

instructions meet its stringent settlement criteria. Pairs o instructions are then matched up

and unded beore the trade execution itsel, where payments are made in the specied

currencies. These processes occur on the trade date, in real time and on a continuous basis.

With CLS, banks make payments on the net position o each currency, rather than on agross transaction-by-transaction basis. This reduces the unding necessary or individual

transactions by up to 90%. For example, according to the Economist, a single payment

[to CLS] o a ew million dollars, yen or euro is enough to settle a banks multiple trades

scheduled in that currency or that day, even though their gross value may be hundreds o

millions o dollars.1 This has helped promote the increase in trading that has shaped the

FX market over the past ve years.

As well as eliminating settlement risk, CLS also delivers real-t ime settlement inormation

that helps members to manage liquidity more eciently, reduce credit risks and increase

operational eciency.

CLS has helped banks in a number o ways. For example, reduced exposure to FX settlement

risk helps European banks reduce their Basel II obligations. Taking advantage o a rapid,

98% reliable settlement system also helps banks improve their overall trading perormance

in quality as well as volume.

tHe Current envirOnment And CHAllengeS FACedby ClS member bAnkSWith its endorsement by the G10 central banks, CLS will continue to maintain a signicant

role in the settlement process. In addition to the obvious benets, however, there are a

number o drawbacks to the CLS system that hold major challenges or banks.

The rst is the act that the elimination o settlement risk through CLS comes at a price. CLS

remains relatively expensive. The entry ees or prospective shareholder and settlement

member banks are prohibitive or all but the largest banks, while membership ees and trade

settlement costs are also high. Some banks have helped oset this cost by using their CLS

membership or revenue generation by selling third-party services. But in todays high

volume environment, using CLS remains a strain on the resources and prot margins o

many FX trading banks something they can ill aord in a market where the need to reduce

costs per trade is paramount or competitive success.

Acow

1 Plumbing Revolution The Economist,November 15, 2002, p. 99.




The second diculty is the act that while CLS currently settles 55% o all FX transactions,

banks still need to nd alternatives to mitigate their risk or the 45% that doesnt fowthrough CLS.

CLS only settles in 15 currencies: US dollars, Canadian dollars, Euro, Japanese yen,

GB pound, Danish krone, Hong Kong dollars, Singapore dollars, Australian dollars, New

Zealand dollars, South Arican rand, Swedish krona, Swiss rancs, Norwegian krone and

Korean won. As the dollar loses its grip on the world o nance, the FX trading market is

becoming increasingly diverse, with trade volumes in currencies such as the Polish zloty

seeing a massive increase. Until CLS widens its scope, banks are aced with the dicult

choice o either missing out on opportunities that lie in currencies not supported by CLS,

or exposing themselves to high levels o FX settlement risk.

The extensive use o algorithmic trading within the FX market also poses unique challenges

or CLS users. Because algorithmic trading generally results in high volume / low-value

trades, settling these trades through CLS may not be commercially viable in some cases

because o its relatively expensive cost-per-trade model. As the number o trade tickets

increase while the value o trades decrease, trading prots or algorithmic trading become

more and more dependent on the settlement cost-per-trade. CLS has responded

by adopting a sliding scale to its cost-per-trade model based on both trade volume and

on the value o each trade a necessary rst step to ensure the commercial viability o

algorithmic trading or its users. As algorithmic trading continues to rise going orward,

CLS will be under constant pressure regarding its settlement cost-per-trade. Banks will need

to constantly monitor the situation and have alternative solutions in place that will help them

minimize trade settlement costs while ensuring high levels o risk management.

Additionally, despite the act that CLS eliminates trade settlement risk, it is not entirely risk-

ree. The Economist claims that CLS Bank may increase a banks exposure to other risks

because the members are entirely reliant on a single entity. From an operational risk

perspective, this raises the question o what might happen i CLS Bank has a breakdown,

since even the smallest interruption o the service would be a global matter, hitting all

15 FX payment systems with a single blow2. Although these considerations in no way

undermine the success and achievements o CLS, they highlight the act that it does not

provide a complete solution to the problem. Banks need to consider CLS as the rst step in

a much wider risk management program, and explore viable alternatives, in order to truly

eradicate FX settlement risk.

Acows

2. RMA Journal, The CLS Bank: Moving BeyondHerstatt to Eliminate Settlement Risk ThroughContinuous Linked Settlement Beverly J. Foster




AlternAtiveS tO ClS

The challenges and limitations o CLS highlight the act that it is a relatively new system withroom or development. CLS will, without doubt, evolve and improve on its current model.

In act, it is already extending its services to include non-deliverable orwards (NDFS) and

FX option premiums. But banks should also take matters into their own hands by exploring

alternative methods o dealing with FX settlement risk. In this way, banks can diversiy their

approach to this kind o risk. This will not only help compensate or the shortcomings o CLS,

but will also make it easier or banks to seize opportunities in currencies and trades that are

not currently supported by this system.

Bilateral netting

A strong alternative to CLS is bilateral netting a legally enorceable arrangement betweena 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 dene which transactions are included in the agreement. The net

worth o all transactions carried out in a single currency within a dened period can then be

settled in a single payment. This helps reduce both risk and the cost o clearing.

This contract creates a single legal obligation covering all included individual contracts.

Banks only exchange the dierence between what each party owes the other. In the event

o the deault or insolvency o one o the parties, their obligation is the net sum o all positive

and negative air values o contracts included in the bilateral netting arrangement.

Cash transactions are still the majority, but more and more derivatives transactions are

bilaterally netted in todays environment. Bilateral netting currently accounts or about

US$1 trillion o 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 sotware vendors are developing tools to identiy potential netters

and even auto-netting acilities to assist in this regard.

A number o pre-payment netting solutions have been recently launched in the marketplace.

Some o these work by receiving deals rom the various dealing platorms and determine

whether or not each deal is netting-eligible based on customer-dened parameters.

Beore 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 nd

their net exposure. This is then processed by the back oce. While these solutions certainly

oer 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.




Same-day or next-day settlement

There are also opportunities or banks to increase the percentage o trades that are settledsame day or next day. The standard time or immediate settlement (usually known as the

spot value date) is two business days ater the trade date (T + 2). The only exceptions to this

convention are US dollars and Canadian dollars, which have a spot value date o T + 1

because they operate within the same time zone. The conventional wisdom is that the two

business days or settlement reduces settlement risk, allowing time or deal conrmation

details and settlement system instructions to go through between counterparties. There are

many who believe, however, that immediate settlement should be shortened to just one

day or most currencies, and that in doing so, the shorter settlement period will signicantly

decrease settlement risk.

A SyStem FOr tHe FutureTechnology also plays a vital part in helping banks deal eectively with FX settlement risk.

Todays banks are under immense pressure to increase their trading volumes at the same

time as reducing operational costs and increasing prots. To achieve this, they must reduce

processing costs per trade and support their trading activity with high-perormance back-

oce systems. Since one o the key pain points around CLS is its high cost, any alternative

must be supported by cost-eective technology.

Equally important is the issue o scalability. The current FX market is marked by phenomenal

growth and banks cannot aord to keep investing in new systems to cope with ever-

increasing trade volumes. By selecting back-oce technology that is capable o processing

unlimited transaction volumes, banks can saeguard themselves rom back-oce

ineciencies that might hinder their growth.

Web-enabled unctionality is also crucial or back-oce systems. By exploiting web tools,

banks can shit responsibility or many non-STP processes to their customers. This ulls two

unctions. On the one hand it is advantageous to the bank, helping to reduce the cost o

some o its back-oce processes and making it easier to allocate in-house resources more

eciently. At the same time, web-enabled access to the banks back-oce system provides

customers with the increased levels o control and transparency they demand.

Research rom TowerGroup predicts that in 2007, global FX daily average volumes will

exceed US$3 trillion. Banks need to ensure that their back-oce systems can cope not only

with high trade volumes, but also with the number o trade tickets that fow through the

system. Todays traders are trading smaller ticket sizes, but in much greater number o

tickets. As algorithmic trading continues to be a powerul driver in the FX market, the

volume o tickets processed will continue to grow signicantly aster than the notional

dollar amounts traded. Electronic trading continues to grow and this year will account or

more than 44% o this volume. This trend is placing signicant pressure on back-oce

inrastructure because o the relatively high costs associated with processing trade tickets

and trading banks must ensure that they are prepared to cope both now and in the uture.




Clearly, todays banks cannot continue

to rely exclusively on CLS or their FX

settlement risk needs. The trade settlement

process has evolved signicantly over the

past 30 years CLS being just the latest

stage o a much larger evolving process.

In short, banks need to implement

additional risk management strategies

that sit alongside CLS and enable

settlement across all FX trades and

all currencies, as well as being more

accessible to smaller banks.

By establishing such a ramework o

alternative strategies including bilateral

netting and same-day or next-daysettlements banks can create a more

eective, fexible settlement strategy

while removing the risk o dealing with

a single entity.

Banks are already investigating lower cost

alternatives to CLS. The emergence o

viable alternatives will create a competitive

atmosphere, which will eventually drive

down the cost o settlement per trade rom

dollars, to cents, to basis points. Some CLS

shareholders are already using CLS purely

to mitigate settlement risk and choosing

bilateral netting to produce payment

instructions. Other banks will ollow suit,

which may have an impact on CLS in

the uture.

Crucially, it is the technology a bank

uses that will make these eorts successul.

To eciently and cost eectively dealwith FX settlement risk, banks will need to

implement powerul back-oce systems

that can cope with high volumes o

transactions and trade tickets, and support

connections to the multiple settlement

systems that exist in the marketplace.

COnClUsiOn


11/12


12/12

2007 Wall Street Systems Delaware Inc

www.wallstreetsystems.com

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Email [email protected]

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