Continuous linked settlement at last

The imminent implementation of T+0 settlement for foreign exchange ought in theory to be an all-round blessing for market participants, reducing Herstatt risk. Some banks will, however, fall outside the system, raising the possibility of a two-tier market with differential spreads. Members will also incur new risks.

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Almost exactly five years after it was first announced, and after numerous delays, continuous linked settlement (CLS) is on the verge of becoming a reality. And with the backing of central banks in the G7 countries, plus 70 shareholder banks, everyone involved in the foreign exchange markets should sit up and take notice.
Forex is the largest market in the world, with an estimated daily volume of about $2 trillion. Trades usually settle in T+2 or T+3, which means that at any one time the settlement risk on banks' books worldwide amounts to at least $4 trillion, millions of which go astray each day.
Ever since the collapse of German bank Herstatt in 1974, banks have been aware of this risk. But taking less risk would tend to reduce an institution's earning potential, which is why banks preferred to live with Herstatt risk for 23 years before agreeing together to reduce it.
CLS is a settlement service that will facilitate T+0 in the forex markets. It was born of pressure put on market players by central banks to reduce settlement risk. Recommendations were made in a 1996 BIS report, known as the Allsopp report. Almost a year after the report was published an initial group of 20 banks announced the CLS project.

Through technology developed by IBM, CLS will provide forex players with same-day payment and settlement. It works through an entity called CLS Bank, which will provide a system for matching settlement instructions with funds received before distributing payment among forex counterparties. CLS Bank is regulated by the US Federal Reserve.
The central banks' payments systems, or real-time-gross-settlement (RTGS) systems, are integral to the CLS process. Payments pass through settlement member banks, which either pass those funds on directly to the relevant RTGS system for cross-border delivery, or to nostro agents (banks operating in the country of a given currency) that then pass the funds to the RTGS system. From there the funds go to CLS Bank for matching. Any funds that cannot be paid because of insufficient amounts, or because of counterparty delay, are returned to the original counterparty. CLS Bank itself never holds any funds.
It is the ability to return funds not payable that takes the settlement risk out of forex. "You can keep on making payments because you know you'll get your money back [if the trade doesn't settle]," says Jeffrey Manton, director of communications at CLS Bank. "There's no danger of it passing to the other side [without the corresponding payment being received]."
CLS is not, however, a perfect solution. Adrian Bates, assistant treasurer, operations, at UK pharmaceuticals company GlaxoSmithKline, says: "The question is being asked whether CLS, as it is currently structured, really meets the required objective. After all, it is potentially replacing one set of risks with another."
A two-tier market?
CLS's main objective is to reduce settlement risk, not entirely remove it. Only trades eligible for CLS - those executed by member banks in the G7 currencies - can be settled using CLS. All other trades incur the usual levels of risk. This higher risk in non-CLS trades may mean that banks will find themselves in a position where they have no choice but to become CLS members, or to use a CLS settlement member bank to settle their forex trades. If they do not, they risk being penalized by CLS members, which include the biggest banks.
Opinion is divided about the likelihood of such penalization in the open markets, and no bank will openly admit an intention to deliberately widen spreads on non-CLS trades. But spreads should be a fair reflection of reconciliation risk within any given trade, and trading with non-CLS counterparties exposes CLS members to risk they could avoid.
The danger in this is that a two-tier market will evolve, split between CLS and non-CLS spreads. This is especially likely if the central banks decide to impose solvency requirements on non-CLS trades. "Small and mid-sized banks may find themselves without any choice," says Joerg Pinkernell, head of the GTS product management, settlement and liquidity group at ABN Amro. "They may not find a counterparty willing to deal outside of CLS. The central banks [do not disclose their intentions] but if they add extra solvency requirements to non-CLS trades - and I think they are looking into that - I'm absolutely sure there will be a two-tier market."
Liquidity risk is the new worry
CLS also incurs liquidity risk. CLS member banks must provide enough short-term liquidity to settle trades same-day, which they are not used to doing. Each bank must meet the challenge of internal back-office organizational and operational changes and must weigh up the costs of daylight overdrafts, collateralization, and moving liquidity from one system to another. And then still there is the task of managing mark-to-market risk on funds returned. Though all these things are possible, there are concerns, even at CLS, that the provision of short-term liquidity will falter in the first few weeks.
Concentration risk is also a danger of CLS. At launch, which is scheduled for some time this summer, CLS will clear funds in Australian, Canadian and US dollars, euros, sterling, Swiss francs and yen. Given these currencies and the banks that are on the system, CLS will immediately be capable of capturing about half the daily volume in forex settlement. As more currencies are added - the Singapore dollar and the Scandinavian currencies have already been approved, and the Hong Kong and New Zealand dollars are under consideration - and as more banks come on board, settlement flows may increase up to as much as 80% of the market. If this happens, any failure of CLS will have serious consequences. Though in theory funds are returned if not paid, and other methods of settlement still exist, some observers are nervous at this prospect.
The fact remains, however, that forex settlement risk needs to be reduced, and CLS is the market's best and only option at present. Jeanne Capachin, research director at Meridien Research, adds: "[Settlement risk] is too big a problem not to have a solution. Reducing that risk is the main goal of CLS. Any other benefits that CLS brings to the financial community are secondary."
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