ALTHOUGH CLS BANK was officially launched on September 9 2002, its conception can be traced back far further to the afternoon of June 26, 1974. On that day, the German authorities shut Bankhaus Herstatt, with ramifications that were to spook the regulators for the next quarter of a century.
Herstatt was a relatively active participant in the foreign exchange market whose closure highlighted a big weakness in the FX market’s settlement method. According to Gabriele Galati of the Bank for International Settlements (BIS), writing in the BIS Quarterly Review, December 2002, Herstatt’s closure started, "a chain reaction that disrupted payment and settlement systems. Its New York correspondent bank suspended all US dollar payments from the German bank’s account. Banks that had paid Deutschemarks to Herstatt earlier that day therefore became fully exposed to the value of those transactions."
As Galati went on to say, the collapse highlighted the risks that were inherent in traditional FX settlement. These were present because settlement normally occurred in a currency’s country of issue and in some cases there was and remains a significant time lag between the settlement of any trade’s two legs. The scale of the problem was exacerbated even back in 1974 by the sheer size of the FX market; this raised the spectre of a systemic collapse.
By 1996, with FX volumes seemingly on a never-ending upward path, the G10 central banks advocated a strategy to reduce this potential settlement flaw. Among the results was the creation of CLS Services in 1997, which led to the eventual launch of CLS Bank in September 2002. However, even before it had gone live, CLS was attracting a steady flow of negative comment from many industry participants. It was not only late and over budget, they argued, but it was very much seen in some quarters as an initiative that had been forced on the industry as a result of the collapse of a bank in a different era. Many pointed out, perhaps with some justification, that the industry itself had responded to the perceived problem and taken sensible steps to reduce settlement risk, most notably with the acceptance and then growing use of netting.
Switch forward five years, and it is clear that CLS has proved extremely successful at what it was intended to do, which is to remove settlement risk from FX transactions. According to a consultative report by BIS’ Committee on Payment and Settlement Systems ("Progress in reducing foreign exchange settlement risk", July 2007), which surveyed 109 institutions that are responsible for 80% of the turnover in 15 currency areas, CLS now settles 55% of the FX market’s turnover. Of course, that does not mean it is perfect and the CPSS points out that there is more that CLS could do; CLS concurs in this view.
However, some participants still refer to CLS as a bad tax on the industry, even claiming that its costs are acting as a choke on further growth in the market. Others though, readily enthuse about it, pointing out that far from stifling expansion, CLS has played a big role in stimulating it. As for being expensive, its fans could argue that it has introduced huge operational efficiencies, which means that overall trading costs are actually lower within the CLS settlement environment than outside it.
"With regards to efficiency gains for the back office, and in particular regarding funding simplicity, CLS has exceeded expectations," says Martin Rettich, managing director, custody and transaction services at Credit Suisse. "In terms of settlement risk elimination, there is industry-wide consensus that this paramount objective has been fully met."
Tellingly, CLS worked as it should when it faced its biggest test as a result of the collapse of US broker Refco in October 2005. Although some trades were pulled from the system, leaving some of Refco’s counterparties with market risk, CLS’s payment-versus-payment (PVP) model meant that the problems were relatively minor from a financial perspective. The spectre of millions of dollars going missing down some dark settlement hole failed to materialize and the system remained intact.
Of course, complaints will always follow if money is lost as a result of an outside and unexpected influence. In the Refco saga, there were gripes that some trades could not settle at the rates they were done at because CLS allowed the bank that handled Refco’s CLS obligations through a third-party arrangement to pull the deals it did not like out of the system.
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"We asked members if they want CLS to provide guaranteed settlement – they said they didn’t"
Rob Close, CLS Bank |
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"When Refco imploded, some trades did get pulled when it went into insolvency. CLS provided the market with excellent information on the funding implications of these instructions being rescinded," says Rob Close, chief executive of CLS Bank. "Some of these banks queried whether these instructions should have been rescinded. CLS doesn’t cover pre-settlement risk and therefore does not guarantee settlement from the time of the trade. There was some confusion about this at the time and so we asked members if they want CLS to provide guaranteed settlement – they said they didn’t."
As well as eliminating settlement risk in the currencies that it handles, CLS has had other beneficial effects that not everybody predicted. Before its launch, some had expressed concerns that CLS would lead to the creation of a two-tier market that would result in non-members having to trade on wider spreads. This has not happened, mainly because of the success of the third-party services that CLS member banks provide. "Initially, there was an expectation that spreads would widen for non CLS-members. We haven’t experienced this but rather that trading facilities [lines] for non-members have not been extended as much as CLS members," says Ed Pla, global head of FX Prime Services at UBS. "In addition we believe that CLS Third Party brings advantages especially in terms of processing and consequently cost reduction."