There is widespread agreement that CLS – the continuous linked settlement system – has performed an admirable job since it started operations in September 2002. Its effective removal of settlement or Herstatt risk for the majority of foreign exchange transactions is often cited as one of the catalysts for the recent growth in the market. However, as it approaches its fifth anniversary, CLS is frequently seen in some quarters as acting as a brake on further market expansion because its business model has become anachronistic.
The main issue is that CLS does not allow pre-netted trades to be submitted for settlement. As it charges on a per ticket basis, its users have had to pay more as the number of deals they put through CLS rises. CLS has reduced its tariffs as volumes have increased but this has not totally silenced the chorus of complaints from some quarters.
CLS’s model reflects how the market used to be, not what it has become. The FX market has changed radically since CLS’s conception. In particular, the growing use of electronic trading has resulted in a whole new range of participants flocking to the market, such as high-frequency traders that trade smaller amounts far more frequently than used to be the case a decade ago. Another issue is that the acceptance of FX as an asset class has led to the more active management of currency exposure by real money accounts, and when they trade, they frequently want to have deals allocated to multiple different accounts.
The result is that the growth in ticket volumes has outpaced the increase in volumes and at times some banks have struggled to process the vast number of deals they are doing with their counterparties. With volumes predicted to increase yet further, CLS is becoming seen as a burden – described by some as a bad tax on the industry – both in terms of cost and the stresses it imposes on back offices. Given its ownership structure, CLS itself is naturally aware of the issue.
Capacity constraints
“The change in the market, particularly the emergence of high-frequency trading, has changed the dynamics for a number of banks. Some are anticipating the point where they are processing 100,000 tickets a day, and there are capacity constraints. Others think it [capacity] may become an issue,” says Jonathan Butterfield, executive vice-president of communications and marketing at CLS.
“As part of a broader review the board agreed that CLS go out and see if there is anything we can do [to alleviate the ticket processing pressures],” he adds. The report is due to be presented at CLS’s April 26 board meeting. Butterfield says that, so far, the feedback from users has been mixed but that end users have been frank and candid.
“We are exploring the beginnings of a solution. We understand business managers’ concerns and issues and we are moving at a reasonably high speed. This is all about cost containment, minimizing capacity investment and responding to fee compression. We are around two-thirds of the way through the investigation process and have several potential solutions we will discuss with member banks,” he says.
According to Mel Gunewardena, managing director, head of fixed-income prime brokerage at Deutsche Bank, there is a sound logic in allowing pre-netting. “What we have seen is a growth in spot electronic trading where most deals, when netted down every day, result in very little settlement risk. By processing each trade through all of the operational systems and submitting each trade individually it could be argued that it can increase operational-type risks, particularly if volumes continue to grow. Individually processing thousands of trades can create capacity issues and bottlenecks in back-office systems,” he says.
“We strongly believe that pre-netting is the appropriate method for trades that are short dated and ultimately account for little settlement risk,” he adds.
Caution
But Martin Rettich, managing director, custody and transaction services at Credit Suisse, suggests that some caution is needed. “We’re following what’s being proposed. As a shareholder in CLS, we have to be aware of the impact [of pre-settlement netting],” he says. “Pre-netting addresses certain technical issues but we’re far away from making a decision [whether it is the right solution]. It really is all about the high-frequency traders. It’s a serious issue for some of these. CLS has eliminated settlement risk, improved liquidity management, reduced operational banking costs and improved operational efficiency and effectiveness. My concern is that if we do go the pre-settlement route, we’ll have three settlement paths. There will be the traditional way (outside of CLS), payment versus payment through CLS and then pre-netted settlement.”
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“My concern is that if we do go the pre-settlement route, we’ll have three settlement paths: the traditional way outside of CLS; payment versus payment through CLS; and then pre-netted settlement” Martin Rettich, Credit Suisse |
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Butterfield also points out that if CLS does change its model, end users will have to make alterations to the back-office infrastructure, which would possibly require investment, including in rehiring staff. However, as Jeremy Smith, director at consultancy Z/Yen says, while extra staff might be needed, once they were in place, pre-netting would be extremely efficient. “The introduction of pre-settlement netting would show that CLS is moving with the market. Don’t forget that the creation of CLS is one of the main factors which allowed the growth that’s taken place in FX to occur,” Smith adds.
Pre-netting inevitable
Jack Jeffery, chief executive, Icap electronic broking, thinks the introduction of pre-netting is inevitable, but stresses that others, not just CLS, could offer it. “I think that netting in the interbank market will happen and that is one step that CLS could take. Our view is that CLS does a great job, but a combination of what we both can provide answers many problems that exist in the market.”
Recently, Icap’s EBS unit unveiled its Netlink joint venture with Traiana to provide a netting service between prime brokers and their clients. ICLS has said it will allow these trades to be settled through it. Jeffery says Netlink could easily be extended to provide an interbank solution.
Even though CLS is unlikely to impose a monopoly if it allows pre-netting, Jeffery believes there will be no room for more than two offerings. Clearly he believes Netlink will be one of them, but Butterfield believes that CLS might have an advantage, because it already has the ability to ‘see’ across multiple platforms.
“Some banks are keen for us to offer pre-netting,” Butterfield says. “We are seen as a legitimate provider, but we will have to move quickly if the board and we decide to proceed. We would then be able to offer gross and netted settlement. It obviously has a knock-on effect on our business model and that will have to be considered very carefully.”
Deutsche Bank agrees with this assessment, stressing that CLS is a widely respected utility that has good relationships with all the major banks in the industry. But clearly, as Credit Suisse’s Rettich stresses, users will need to carefully model the impact pre-settlement has on the overall CLS business.
“CLS has a huge fixed cost and the original model was based on volumes. With the changing nature of the markets, it needs to examine all aspects of the business,” he says, adding that it is looking at introducing new products, such as non-deliverable forwards and the settlement of option premiums. He also points out that CLS has been selected by the US Depository Trust & Clearing Corporation (DTCC) as a global settlement partner for OTC derivatives market. “Should CLS become the global infrastructure for settlement?” he asks.
Best solution
So far, few people if any appear to have carefully analysed the true cost of settlement versus operational risk. Once this is done, the industry might well decide that a combination of pre-netting and CLS is the best solution to take the market forward. If so, the market’s leading participants will have to decide, with CLS, what is the appropriate fee that ensures the utility’s viability, because even though a netting service will not be free, the revenue it generates is not going to match that paid for gross settlement.
Delivering a quality service at near cost looks crucial. “It is a utility and it makes sense for it not to make a huge profit,” says Z/Yen’s Smith. Gunewardena agrees. “CLS is an industry utility and it serves an important role,” he says. “We’re committed to CLS but there are challenges it has to face. CLS has helped the industry grow before and I expect it to play an important role going forward,” he says.
