Even with the creation of Continuous Linked Settlement Bank (CLS), foreign exchange settlement risk persists, with a large number of currencies remaining outside the scope of the industry utility. How much risk persists, and how can it be eliminated? Writer Frances Maguire.

Continuous Linked Settlement Bank (CLS), launched in 2002 to eliminate counterparty risk from foreign exchange (FX) transactions, and which currently settles on average more than $3000bn each day in FX-related payment obligations, has been hailed as the biggest single mitigator of the systemic risk arising from the settlement of FX trades, as identified by the G10 central banks in 1996.

But according to an April 2006 survey prepared for the Committee of Payment and Settlement Systems (CPSS), in which the industry’s progress during the past 10 years was examined, there are some significant gaps in the system, with just 55% of FX transactions actually settled through CLS. This begs the question, how much risk prevails in the system, and how are the outstanding transactions settled?

Behind the stats

True, the CPSS figure is now almost three years out of date, and in its report ‘Progress in reducing foreign exchange settlement risk’, published in May 2008, the CPSS went on to note that CLS was growing rapidly. It said that the April 2007 daily value average was 23% higher than that during the survey period a year earlier.

Furthermore, the CPSS reported that 75% of those institutions surveyed in 2006 expected CLS to increase its overall share in industry-wide settlements over the next one to three years by at least another 10 percentage points, to 65% or more. In addition, 53% of the surveyed institutions (including 55% of non-users of CLS) expect to settle more of their own trades through CLS, reflecting an expectation that a growing number of trading counterparties will become CLS users, as well as the belief that CLS will introduce new services for settling FX trades.

Jonathan Butterfield, executive vice-president, marketing and communication for CLS Bank International, argues that the number of transactions open to settlement risk is much lower than these figures initially suggest, adding that it is extremely difficult to get a truly reflective overview of FX settlement risk. “We look very hard at the six-monthly reports that come out from the FX Committee and the Joint Standing Committee on Foreign Exchange to see what they are saying about the mix of business and the growth of business. The issue we have with those reports is they double count,” he says.

For example, if a trade is performed between London and New York it will be counted in both the London and New York statistics, adds Mr Butterfield. “This is one of the frustrating reasons why FX remains difficult to measure absolutely. To get the real net number, a lot of work is needed to clear out double counting, which is why the Bank for International Settlements’ tri-annual survey retains its position as the primary source.”

With the growth of CLS since the last CPSS survey was carried out, Mr Butterfield estimates that the target market growth for CLS is now closer to 15% of daily value than the 45% suggested by the 2006 results. Some small values are also settled using alternative types of settlement, such as the industry utilities that exist in other countries, and through the use of netting procedures. “In terms of the overall percentage, CLS is pretty comfortable that it is achieving 65% of spot [the market for immediate delivery and settlement of currencies] and that is still a growing proportion of value we settle, whereas the swap business has declined,” he says. “CLS values have grown at higher rates than reported by the various FX committees earlier in the year, as risk factors encouraged participation. We are all awaiting the October reports due shortly to see the impact of [the recent] turmoil and the demise of major participants.”

Underlying risk

However, despite this growing improvement, the CPSS says that a notable share of FX transactions are settled in ways that still generate significant potential risk across the global financial system. Of the 45% of settlement obligations not settled by CLS, 32% of the settled obligations surveyed were done through traditional correspondent banking arrangements and subject to settlement risk.

Use of correspondent banking leads to exposures when settling FX trades because there is no direct link between the payments of the two currency legs, meaning that there is a risk of paying the currency sold but not receiving the currency bought. Furthermore, half of the value of these obligations were at risk overnight, not just intraday. The CPSS also noted that some bilateral settlement exposures were large relative to capital and not well controlled, with 63% of surveyed firms underestimating their bilateral FX settlement exposures.

The survey evidence demonstrates that the FX settlement risk exposure of individual institutions varies considerably, as well as strongly indicating that in total only 34% of surveyed institutions could be said to fully control their traditional FX settlement exposures. Moreover, this finding indicates that there has been no significant improvement in this regard since the CPSS’s much earlier survey on the subject conducted in 1997, when only 35% of institutions had fully appropriate controls. It indicates a minor regression.

According to the CPSS, individual institutions can take further steps to reduce and control appropriately their remaining FX settlement exposures, and it outlines various mechanisms by which they can achieve this. These include payment-versus-payment ser­vices such as CLS, by using legally robust bilateral netting or by better control of settlement using traditional correspondent banking. But the report also states: “Further progress in these respects depends upon: the scope for existing and prospective service providers to offer new risk-reducing services for settling FX trades; the extent to which the potential risks from using bilateral netting are appropriately controlled; changes in the use of traditional correspondent banking; and perhaps most importantly, the incentives for individual institutions to reduce and control appropriately their remaining exposures.”

The survey showed that at least 36% ($400bn-worth) of the FX obligations subject to settlement risk were between CLS users, and discussions with the surveyed institutions suggest that much of this was accounted for by same-day and certain next-day trades, trades involving a non-CLS currency or the outside leg of ‘in/out’ swaps. These are trades that currently cannot be settled using CLS, due to either the timing of the CLS settlement cycle or, in the case of non-CLS currencies, ineligibility to settle in CLS.

By the book

CLS believes that the book transfer business within banks, the second largest component of FX settlement, is at least 25% of the ­market. A lot of the hedging trades that are performed, particularly by the corporate sector, will be done with their banks, and that will never be settled in CLS, along with the currencies that CLS does not settle.

Understandably, there will always be some FX settlement that is managed within the banks. The business on the banks’ books, between the bank and its customers, would potentially be eligible for CLS, but it is not widely expected that it would be settled through the utility. Mr Butterfield adds: “The debit and credit between the bank and its client should be very timely. Settlement risk is about a gap, and not knowing whether the exchange of funds has occurred. So if a cash management bank with corporate clients can do the debit and credit within its own house, this should effectively eliminate settlement risk.” He adds: “The issue has always been when there was an exchange between two separate entities that both needed to move money externally and remotely.”

Managing risk

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Sang Lee, co-founder and managing partner at analyst firm Aite Group, says that there are many different ways of managing FX settlement risk from a customer business perspective.

“Banks can opt to net risk with the customer intraday, margining the customer (for example, a prime brokerage arrangement), get settlement through CLS third-party settlement arrangement, try to pass on the risk to another bank, or taking the risk on the balance sheet gross and reducing the available line to that particular counterparty by the gross amount. Typically, you would see combination of all of the arrangements in the customer business side,” says Mr Lee.

Additionally, Mr Butterfield says that the concern about settlement risk is now a front-office issue, not just an operational one, and CLS has had a record level of enquiries as member banks work to bring in the outliers. This pressure is likely to continue unabated throughout 2009. At the moment, CLS settles FX transactions in 17 currencies, but discussions to bring on board new currencies are continuing with several jurisdictions, and are at varying stages in the process. Mr Butterfield says that adding a new currency takes time because CLS cannot afford to put undue risk or strain on the world’s largest currencies.

The bank is in discussions with Brazil, Chile, India, Thailand and Turkey, and it has an ongoing dialogue with China. “If we add a weaker currency we are fundamentally changing the risk ­profile for the major currencies, given the interconnected nature of the service. There is a growing view that some of the discipline of the CLS settlement cycle needs to start being pushed in other markets to get quicker matching times and therefore tighter control over exposures,” says Mr Butterfield.

Currency divide

For this reason, a new currency cannot be added to CLS until the country has a stable economy and finance system, and a robust legal system that can adequately protect worldwide participants and prevent other currencies from being damaged. CLS’s non-deliverable forwards (NDFs) service is much more flexible as CLS does not physically ­settle the currencies and is able to add new “reference currencies” quickly on demand.

The service covers NDFs in 49 reference currencies. CLS defines NDFs as short-term forward contracts on a thinly traded or non-convertible foreign currency, where the currencies are not physically delivered, and instead, the profit or loss is calculated by taking the difference between the agreed upon exchange rate (normally but not exclusively quoted and settled in US dollars) and the spot rate at the time of settlement, for an agreed upon notional amount of funds.

Mr Butterfield says that there are a number of currencies outside CLS that are tradable and potentially eligible. For a currency to be included, however, the government of that currency must be comfortable with the policy aspects and the central and commercial banks must support the project, before it makes sense to begin the process. There are other elements that need to be covered and though CLS has a well-used roadmap for adding currencies, the projects do take time, says Mr Butterfield. For these reasons, it is likely that the dual system in place today will remain, with those smaller currencies not included in CLS instead going through a correspondent model.

Apart from the addition of more currencies, the only way that FX settlement risk can be reduced further is by wider participation in CLS by the global banking community. There are a total of 4150 third-party members of CLS who participate through member banks, and in 2008 an additional four banks signed up as direct members of CLS. What has changed in this respect, according to Mr Butterfield, is that the front offices are now urging more of their counterparties to settle in CLS.

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However, the fact still remains that a key barrier to the wider adoption of CLS is the cost. Andrew Wilkinson, senior market analyst at Interactive Brokers Group, a broker-dealer and proprietary trading business, says:

 

“We would love to use CLS for FX settlements since it mitigates settlement risk, but the cost is prohibitive. We do use CLS for quarterly Chicago Mercantile Exchange settlements, and currently only use the large FX dealers to reduce over-the-counter FX counterparty risk.”Furthermore, Mr Wilkinson adds, the pricing structure is another barrier to entry: CLS charges per trade rather than per settlement, which results in tight margins between banks and brokers.

Central counterparty

With the recent demise of FX MarketSpace, an FX central counterparty created by a joint venture between Reuters and the Chicago Mercantile Exchange, it is clear that the wider use of CLS is the most obvious answer to eliminating settlement risk available to the FX industry. This means that it is important that the utility attracts more member banks, that existing users increase the volume of business put through CLS, and that more currencies are added to CLS.

The main reason that traditional correspondent banking continues to be used for FX settlement is due largely to the occasions on which one or both currencies are not settled by CLS. The creation of a dual system in FX, divided between those currencies in and outside the scope of CLS, is understandable. But in a risk-averse environment, with ever-more eyes focused on the underlying infrastructure of the markets, the persisting FX settlement risk may well force a revision of the CLS model in order to encourage wider use and this, in turn, may require an overhaul of its pricing model.

 

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