Optimizing settlement risk management: A White Paper by Wall Street Systems

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1 Optimizing settlement risk management: CLS and beyond A White Paper by Wall Street Systems

2 CONTENTS Introduction 3 CLS: solving the settlement risk conundrum 4 The history of FX settlement risk 5 The Herstatt Incident 5 The formation and significance of CLS 5 The CLS process and its effect on FX trading 6 The current environment and challenges faced by CLS member banks 6 Alternatives to CLS 8 Bilateral netting 8 Same-day or next-day settlement 9 A system for the future 9 Conclusion 10

3 INTRODUCTION Foreign exchange (FX) settlement risk the risk of a bank in a foreign exchange transaction paying the currency it sold without receiving the currency it bought is one of the biggest concerns in today s international banking community. As the FX market continues its trend of exponential growth year on year and average daily trade volumes today exceed $US3 trillion, it s not surprising that FX settlement risk has dominated the G10 Governors agenda for over ten years. FX settlement failures can arise for a number of reasons: counterparty default, operational problems and market liquidity constraints are just a few examples. Settlement risk is inherent in any trade activity, but it is the size of the foreign exchange market that makes FX settlement risk such an important issue for many banks, FX transactions are the greatest source of settlement risk exposure. In some cases, large banks have almost three times more exposure to settlement risk than to credit risk. The sums of money involved are huge FX transactions can involve credit exposures amounting to tens of billions of dollars each day, and in some cases, exposures to a single counterparty are in excess of an institution s capital. Settlement risk has historically been a problem in foreign exchange markets because, due to time zone differences, several hours might elapse between a payment being made in one currency and the offsetting payment being made in another currency. The introduction of Real Time Gross Settlement (RTGS) has eliminated some of these risks by providing real-time settlement. But challenges remain as speed and real time transactions become more and more important in all areas of finance, including FX transactions.

4 CLS: solving the settlement risk conundrum Continuous Linked Settlement (CLS) is a real time, global settlement process that reduces settlement risk caused by foreign exchange transactions occurring across different time zones. With CLS, both sides of the FX transaction are settled simultaneously significantly reducing settlement risk in the FX market. CLS is essentially a Banker s Bank for FX settlement. It began operations in September 2002 with the purpose of settling foreign exchange flows between some of the world s largest banks along with their customers and other third-party participants. With CLS, both sides of the FX transaction are settled simultaneously on a payment versus payment (PVP) basis. This ensures that all payments and receipts for an FX trade occur simultaneously, eliminating settlement risk. On average, CLS netting efficiency is in the region of 98%. As a result, it has rapidly become the market-standard for foreign exchange settlement between major banks, settling approximately 400,000 instructions a day in 15 currencies. This represents 55% of global FX trading. Despite this high success rate, CLS has some disadvantages. Membership fees are high, and the service is relatively expensive on a cost-per-trade basis. Lowering this cost-per-trade remains a high priority for many CLS users. And while CLS settles over half of the total FX obligations worldwide, banks must still find alternatives for the remaining 45%. Furthermore, banks face capacity issues because the volume of tickets being processed is rising faster than the total notional dollars being traded. Additionally, the high cost of processing these trade tickets is having a negative effect on margins. As trade volumes continue their steady increase, it has never been more important for banks to develop a flexible, adaptable trade-processing infrastructure that will help them to reap the greatest profit from their FX trading activity.

5 The history of FX settlement risk The foreign exchange (FX) market as we know it today emerged in 1971 following the collapse of the Bretton Woods agreement a system of international monetary management established following the Second World War. The new system for currency exchange brought with it the hazard of cross-currency settlement risk. Any bank purchasing currency immediately risks the full amount of currency purchased from the time that the payment instruction is confirmed and can no longer be cancelled unilaterally, until the time the currency purchased is received and the transaction is final. Although FX settlement risk was immediately recognized and understood, its effects were not fully appreciated until The Herstatt Incident On 26 June 1974, the banking license of a German bank, Bankhaus Herstatt, was withdrawn by local regulators. Although the bank was relatively small, its collapse had global implications because of the losses suffered by its FX counterparties. It was ordered into liquidation during the banking day, but after the close of the German interbank payments system at 15:30 local time. Some of Herstatt Bank s counterparties had paid Deutschmarks to the bank, believing they would receive US dollars later the same day in New York. But when the banking business was terminated, it was only 10:30 am in New York. The New York correspondent bank suspended all outgoing US dollar payments from Herstatt s account; leaving its counterparties fully exposed to the value of the Deutschmarks they had paid the German bank earlier in the day. The Herstatt case brought the issue of settlement risk to the attention of the international finance community, but unfortunately it was not the last incident of its kind. More recent examples of what is sometimes still referred to as Herstatt Risk include the collapse of Drexel Burnham Lambert in 1990, the fall of Bank of Credit Commerce International in 1991 and the collapse of Barings Bank in 1995, all of which had global implications related to FX settlement risk. Over the years, FX settlement risk has provoked intensive study and research, including: The 1989 Angell Report on Netting Schemes Noel s 1993 Central Bank Payment and Settlement Services with respect to Cross-Border and Multi-Currency Transactions The 1996 Allsopp Report entitled Settlement Risk in Foreign Exchange Transactions In 1996, a study by the G10 central banks found that banks foreign exchange settlement exposures to their counterparties were in many cases extremely large relative to their capital, lasted overnight or longer, and were poorly understood and controlled. To try and resolve these issues, the G10 launched a high-profile project to tackle the issue of FX settlement risk by devising a strategy to improve the understanding and management of settlement risk, as well as reduce the systemic risk arising from the settlement of foreign exchange trades. The formation and significance of CLS Following the 1996 study, the G10 member banks agreed to the continuous linked settlement concept, which allowed for the simultaneous exchange of currencies and thus eliminated settlement risk. In 1997, the banks launched CLS Services, a private, not-for-profit group owned by major trading banks and brokers, with the aim of developing a specialist bank to handle settlement processing. CLS Bank was launched five years later and is based in New York. It settles foreign exchange flows for CLS members, their customers, and other third parties. Over the past five years, CLS Bank has had a wide and positive effect on the FX trading community. It has completely eliminated settlement risk on the FX trades it processes.

6 Acknowledgement 1 Plumbing Revolution The Economist, November 15, 2002, p. 99. The CLS process and its effect on FX trading CLS follows a well-defined set of processes. A single multi-currency account is created for each settlement member. Accounts are credited when funding pay-in occurs and debited when funding pays out. Each member has its own account with CLS Bank from which it sends and receives currency payments. Members submit their instructions details of payments in specified currencies to CLS on a daily basis. Before daily settlement commences, CLS provides the net cash position to each member and ensures that all instructions meet its stringent settlement criteria. Pairs of instructions are then matched up and funded before the trade execution itself, where payments are made in the specified currencies. These processes occur on the trade date, in real time and on a continuous basis. With CLS, banks make payments on the net position of each currency, rather than on a gross transaction-by-transaction basis. This reduces the funding necessary for individual transactions by up to 90%. For example, according to the Economist, a single payment [to CLS] of a few million dollars, yen or euro is enough to settle a bank s multiple trades scheduled in that currency for that day, even though their gross value may be hundreds of millions of dollars. 1 This has helped promote the increase in trading that has shaped the FX market over the past five years. As well as eliminating settlement risk, CLS also delivers real-time settlement information that helps members to manage liquidity more efficiently, reduce credit risks and increase operational efficiency. CLS has helped banks in a number of ways. For example, reduced exposure to FX settlement risk helps European banks reduce their Basel II obligations. Taking advantage of a rapid, 98% reliable settlement system also helps banks improve their overall trading performance in quality as well as volume. The current environment and challenges faced by CLS member banks With its endorsement by the G10 central banks, CLS will continue to maintain a significant role in the settlement process. In addition to the obvious benefits, however, there are a number of drawbacks to the CLS system that hold major challenges for banks. The first is the fact that the elimination of settlement risk through CLS comes at a price. CLS remains relatively expensive. The entry fees for prospective shareholder and settlement member banks are prohibitive for all but the largest banks, while membership fees and trade settlement costs are also high. Some banks have helped offset this cost by using their CLS membership for revenue generation by selling third-party services. But in today s high volume environment, using CLS remains a strain on the resources and profit margins of many FX trading banks something they can ill afford in a market where the need to reduce costs per trade is paramount for competitive success.

7 The second difficulty is the fact that while CLS currently settles 55% of all FX transactions, banks still need to find alternatives to mitigate their risk for the 45% that doesn t flow through CLS. Acknowledgements 2. RMA Journal, The CLS Bank: Moving Beyond Herstatt to Eliminate Settlement Risk Through Continuous Linked Settlement Beverly J. Foster CLS only settles in 15 currencies: US dollars, Canadian dollars, Euro, Japanese yen, GB pound, Danish krone, Hong Kong dollars, Singapore dollars, Australian dollars, New Zealand dollars, South African rand, Swedish krona, Swiss francs, Norwegian krone and Korean won. As the dollar loses its grip on the world of finance, the FX trading market is becoming increasingly diverse, with trade volumes in currencies such as the Polish zloty seeing a massive increase. Until CLS widens its scope, banks are faced with the difficult choice of either missing out on opportunities that lie in currencies not supported by CLS, or exposing themselves to high levels of FX settlement risk. The extensive use of algorithmic trading within the FX market also poses unique challenges for CLS users. Because algorithmic trading generally results in high volume / low-value trades, settling these trades through CLS may not be commercially viable in some cases because of its relatively expensive cost-per-trade model. As the number of trade tickets increase while the value of trades decrease, trading profits for algorithmic trading become more and more dependent on the settlement cost-per-trade. CLS has responded by adopting a sliding scale to its cost-per-trade model based on both trade volume and on the value of each trade a necessary first step to ensure the commercial viability of algorithmic trading for its users. As algorithmic trading continues to rise going forward, CLS will be under constant pressure regarding its settlement cost-per-trade. Banks will need to constantly monitor the situation and have alternative solutions in place that will help them minimize trade settlement costs while ensuring high levels of risk management. Additionally, despite the fact that CLS eliminates trade settlement risk, it is not entirely riskfree. The Economist claims that CLS Bank may increase a bank s exposure to other risks because the members are entirely reliant on a single entity. From an operational risk perspective, this raises the question of what might happen if CLS Bank has a breakdown, since even the smallest interruption of the service would be a global matter, hitting all 15 FX payment systems with a single blow 2. Although these considerations in no way undermine the success and achievements of CLS, they highlight the fact that it does not provide a complete solution to the problem. Banks need to consider CLS as the first step in a much wider risk management program, and explore viable alternatives, in order to truly eradicate FX settlement risk.

8 Alternatives to CLS The challenges and limitations of CLS highlight the fact that it is a relatively new system with room for development. CLS will, without doubt, evolve and improve on its current model. In fact, it is already extending its services to include non-deliverable forwards (NDFS) and FX option premiums. But banks should also take matters into their own hands by exploring alternative methods of dealing with FX settlement risk. In this way, banks can diversify their approach to this kind of risk. This will not only help compensate for the shortcomings of CLS, but will also make it easier for banks to seize opportunities in currencies and trades that are not currently supported by this system. Bilateral netting A strong alternative to CLS is bilateral netting a legally enforceable arrangement between a bank and counterparty. While multilateral netting models such as the one used by CLS typically involve multiple parties mediated by a clearing house or central exchange, bilateral netting only takes place between two parties. In bilateral netting, banks must agree and draw up a contract to define which transactions are included in the agreement. The net worth of all transactions carried out in a single currency within a defined period can then be settled in a single payment. This helps reduce both risk and the cost of clearing. This contract creates a single legal obligation covering all included individual contracts. Banks only exchange the difference between what each party owes the other. In the event of the default or insolvency of one of the parties, their obligation is the net sum of all positive and negative fair values of contracts included in the bilateral netting arrangement. Cash transactions are still the majority, but more and more derivatives transactions are bilaterally netted in today s environment. Bilateral netting currently accounts for about US$1 trillion of trades daily. Banks are also involved in bilateral agreements that cover cross product and cross structure netting. As banks continue to expand their bilateral settlement agreements on a currency / product basis, third party software vendors are developing tools to identify potential netters and even auto-netting facilities to assist in this regard. A number of pre-payment netting solutions have been recently launched in the marketplace. Some of these work by receiving deals from the various dealing platforms and determine whether or not each deal is netting-eligible based on customer-defined parameters. Before netting, trades are matched by the system to ensure netted trades do not have to be reopened. Banks can data-manage daily trade positions and aggregate them to find their net exposure. This is then processed by the back office. While these solutions certainly offer added value to their bank clients, their value with regards to CLS is limited because CLS currently only accepts deal tickets. They do not accept these netted deals as payment records.

9 Same-day or next-day settlement There are also opportunities for banks to increase the percentage of trades that are settled same day or next day. The standard time for immediate settlement (usually known as the spot value date) is two business days after the trade date (T + 2). The only exceptions to this convention are US dollars and Canadian dollars, which have a spot value date of T + 1 because they operate within the same time zone. The conventional wisdom is that the two business days for settlement reduces settlement risk, allowing time for deal confirmation details and settlement system instructions to go through between counterparties. There are many who believe, however, that immediate settlement should be shortened to just one day for most currencies, and that in doing so, the shorter settlement period will significantly decrease settlement risk. A system for the future Technology also plays a vital part in helping banks deal effectively with FX settlement risk. Today s banks are under immense pressure to increase their trading volumes at the same time as reducing operational costs and increasing profits. To achieve this, they must reduce processing costs per trade and support their trading activity with high-performance backoffice systems. Since one of the key pain points around CLS is its high cost, any alternative must be supported by cost-effective technology. Equally important is the issue of scalability. The current FX market is marked by phenomenal growth and banks cannot afford to keep investing in new systems to cope with everincreasing trade volumes. By selecting back-office technology that is capable of processing unlimited transaction volumes, banks can safeguard themselves from back-office inefficiencies that might hinder their growth. Web-enabled functionality is also crucial for back-office systems. By exploiting web tools, banks can shift responsibility for many non-stp processes to their customers. This fulfils two functions. On the one hand it is advantageous to the bank, helping to reduce the cost of some of its back-office processes and making it easier to allocate in-house resources more efficiently. At the same time, web-enabled access to the bank s back-office system provides customers with the increased levels of control and transparency they demand. Research from TowerGroup predicts that in 2007, global FX daily average volumes will exceed US$3 trillion. Banks need to ensure that their back-office systems can cope not only with high trade volumes, but also with the number of trade tickets that flow through the system. Today s traders are trading smaller ticket sizes, but in much greater number of tickets. As algorithmic trading continues to be a powerful driver in the FX market, the volume of tickets processed will continue to grow significantly faster than the notional dollar amounts traded. Electronic trading continues to grow and this year will account for more than 44% of this volume. This trend is placing significant pressure on back-office infrastructure because of the relatively high costs associated with processing trade tickets and trading banks must ensure that they are prepared to cope both now and in the future.

10 CONCLUSION Clearly, today s banks cannot continue to rely exclusively on CLS for their FX settlement risk needs. The trade settlement process has evolved significantly over the past 30 years CLS being just the latest stage of a much larger evolving process. In short, banks need to implement additional risk management strategies that sit alongside CLS and enable settlement across all FX trades and all currencies, as well as being more accessible to smaller banks. Banks are already investigating lower cost alternatives to CLS. The emergence of viable alternatives will create a competitive atmosphere, which will eventually drive down the cost of settlement per trade from dollars, to cents, to basis points. Some CLS shareholders are already using CLS purely to mitigate settlement risk and choosing bilateral netting to produce payment instructions. Other banks will follow suit, which may have an impact on CLS in the future. By establishing such a framework of alternative strategies including bilateral netting and same-day or next-day settlements banks can create a more effective, flexible settlement strategy while removing the risk of dealing with a single entity. Crucially, it is the technology a bank uses that will make these efforts successful. To efficiently and cost effectively deal with FX settlement risk, banks will need to implement powerful back-office systems that can cope with high volumes of transactions and trade tickets, and support connections to the multiple settlement systems that exist in the marketplace. 10

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12 FOR MORE INFORMATION: North America Headquarters Europe Headquarters +44 (0) Asia Headquarters Website 2007 Wall Street Systems Delaware, Inc.

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