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2013-09-24 13:47:41
CLS keeps the market safe from settlement risk but needs to add more currencies
IT MAY be the most important bit of the financial infrastructure you have never heard of. CLS is one of eight financial market utilities entities that engage in humdrum risk-management activities such as clearing and settlement to have been designated as systemically important by America s Treasury. It has done a remarkable job of mitigating risk in the foreign-exchange (FX) market. But now it is racing to keep pace with the market it protects.
CLS is a bank-owned institution that was launched in 2002 to eliminate settlement risk, one of the biggest dangers in the FX market. The currency markets are the largest and most liquid of all: an estimated $5.3 trillion changes hands every day, according to the latest triennial survey by the Bank for International Settlements (BIS).
Settlement risk is the danger that a bank could lose the principal amount it pays out in a currency transaction. For example, if an American bank hands over $100,000 to receive 75,000 in return from a European counterparty, the American bank risks losing the entire amount if the European bank defaults. Settlement risk is also known as Herstatt risk, after a German bank that failed in 1974 and left many of its counterparties nursing big losses.
CLS solves this problem by ensuring that both sides payment instructions are settled at the same time. It operates a payment-versus-payment mechanism in which instructions from counterparties to an FX trade are authenticated, matched and settled on an agreed date. Since its member banks are conducting lots of transactions, it calculates the net amount of members obligations in each of the 17 currencies it settles daily. CLS settled an average daily value of $2.3 trillion in August.
It sailed through the crisis. Many markets ran aground in the aftermath of Lehman Brothers collapse in September 2008. Thanks to CLS, which provided the certainty traders needed, the FX market continued to function smoothly. That a big chunk of the foreign-exchange market has been let off the hook of post-crisis regulation is in large part because of its reputation.
Ensuring the market continues to operate smoothly is not easy, however. The FX market has grown enormously over the past 11 years, stretching the CLS safety net thin. When CLS started, it processed an average of 5,700 payment instructions each day, and had the technology to handle up to 45,000 if needed. At the height of the 2008 crisis, it processed 1.5m instructions on a single day. On May 28th this year, it set another record of just under 3m instructions. The danger that the utility could be flooded with more trades than it is able to handle is something regulators are acutely aware of.
Equally pressing is the need to bring more transactions into its orbit. Although the 17 currencies covered by CLS account for close to 94% of FX market turnover, the Treasury estimated in July 2012 that only 68% of activity in those currencies settles on the platform. Large volumes are being traded between institutions that are either not one of the 63 direct members of CLS or that prefer to settle by other means.
One issue could be cost. The fees that members pay can vary dramatically from one bank to the next. Through a cost recovery model, fees are set at the start of each year but are then adjusted each month depending on total volumes and on each bank s activity. When the market booms and more trades are settled, costs go down: CLS estimates that the average cost per transaction has fallen by approximately 5% in 2013 as a result of high trading volume in the first half of this year. Even so, heavy investments in technology and risk management have jacked up the headline fees that banks pay.
The greater problem facing CLS is to accelerate the addition of new currencies it settles. The most recent were the Mexican peso and the Israeli shekel, back in 2008. Non-CLS currencies represent only 6.3% of daily volume in the triennial BIS survey but they include some of fast-rising importance, such as the Chinese yuan and the Russian rouble. The yuan vaulted into the top ten most-traded currencies in the latest survey (see chart), although further growth in international trading of the currency could rely, to some extent, on its joining CLS. The Brazilian real, Chilean peso, Thai baht and Polish zloty are also high on the list of priorities.
Under pressure to bring more emerging-market currencies on board, CLS has formed a team dedicated exclusively to the process. In August it opened a branch in Hong Kong to complement its existing bases in London, New York and Tokyo. Adding a currency is not a simple task, however. It requires the full support of officials in the prospective country, from central-bank technocrats right up to the finance minister.
Among a number of requirements that must be satisfied, the biggest sticking-point is that the finality of settlement must be fully recognised within the country s legal framework. In other words, once a transaction has been settled through CLS, a counterparty cannot attempt to reclaim the funds in the event of bankruptcy. However committed CLS is to adding more currencies, legislation can take years rather than months to be passed.
It is not for CLS to drive the agenda and timing, but to facilitate the orderly introduction of each currency, says Dino Kos, a veteran of the Federal Reserve Bank of New York who joined CLS this year to run its regulatory-affairs team and manage the addition of currencies. Perhaps, but if they are not added soon, those currencies will continue to grow outside CLS, jeopardising the smooth functioning of one of the few bits of finance to have had a good crisis.