CLS Third Party Evaluation Guide

Transcription

1 CLS Third Party Evaluation Guide August, 2013 An overview of the potential benefits that an institution should consider when evaluating indirect participation in the CLS settlement service.

2 Contents 1. Executive Summary Third Party Benefits Risk Mitigation and Management Liquidity Efficiencies Operational and IT Efficiencies Business Growth How an Institution can participate as a Third Party About CLS Appendix Calculating the Potential Benefits of Participation Date of issue: August

3 1. Executive Summary This document explains why an institution active in the foreign exchange (FX) market should consider using the CLS settlement service and provides guidance on how it may participate in CLS as a Third Party (TP). CLS has seen tremendous growth in TP participation since the 2008 financial crisis, with the largest growth coming from the investment management community. As of April 2013, more than 9,000 TPs use CLS to mitigate their FX settlement risk. Any institution or fund that trades instruments settled by CLS can derive risk, operational and liquidity efficiencies, and commercial benefits by using a CLS Member that is a Third Party Service Provider (TPSP). TPSPs process all payment instructions and funding on behalf of their customers. TP institutions can be commercial banks, central banks, non-bank financial institutions (NBFI), corporations and investment funds. The CLS Bank International Rules prohibit natural persons as transaction counterparties. TP implementation is delivered by a TPSP which offers connectivity to its CLS interface. This CLS interface is used to send trade instructions and view real-time trade status and settlement information. In many cases, a TPSP will allow a TP to use existing nostro accounts for funding purposes. We recommend that institutions interested in becoming a TP establish whether their clearing bank/custodian bank is a CLS TPSP and explore how to connect to the CLS System. As TPs have no contractual relationship with CLS, the commercial terms and conditions applicable to their use of CLS are subject to bilateral negotiation with their CLS TPSPs. A non-exhaustive list of TPSPs can be found on the CLS website: For additional information on CLS, refer to: For further information on becoming a TP, please contact: relationshipmgt@cls-services.com Date of issue: August

4 2. Third Party Benefits How Can a Third Party Benefit? TPs may benefit from using the CLS service in four key areas: Risk mitigation and management, liquidity efficiencies, operational and IT efficiencies and business growth. Diverse geographic locations and different business models drive different costs and benefits for each TP. CLS can provide the analytical framework to help a prospective TP determine those costs and benefits. The key points for consideration are summarized below, and Appendix 2 provides a template that may be helpful when calculating some of the potential costs and benefits. These benefits apply to all institutions that are active in FX, however different types of institutions will find certain benefits more relevant to their business lines than others. For example: Banks CLS is the established market standard for FX settlement within the banking community. The reduction in trade processing resulting from liquidity and operational efficiencies derived from CLS has helped banks achieve significant volume growth without increasing operational headcount. Funds The investment management industry (e.g. hedge funds, pension funds, overlay funds, custodians etc.) has placed increasing importance on FX trading in recent years. Currency is recognized as an asset class in its own right, investment in crossborder securities has seen increasing interest, and forward contracts are used to hedge currency exposure within a portfolio. CLS allows investment managers to proactively mitigate settlement risk throughout the trade lifecycle. Corporates and NBFIs Corporates and NBFIs operating in the FX market today face a range of challenges, including pressures to reduce risk, improve liquidity management, maximize operational efficiencies and comply with an increasing number of regulatory requirements. Settling FX transactions through CLS can help corporates and NBFIs address these issues. Date of issue: August

5 2.1 Risk Mitigation and Management TPs may benefit from several forms of risk mitigation through their use of the CLS settlement service: Settlement Risk CLS mitigates settlement risk in the FX market through its unique PvP settlement service. The PvP process ensures that the principal amount involved in an FX transaction is protected. CLS simultaneously settles both payment obligations in an FX trade between two counterparties, thereby mitigating the risk that one payment is made without the corresponding payment being made (a risk which arises when the two sides of an FX transaction are settled separately). Pre-Settlement Credit Risk Most trading lines have a significant percentage allocated to daily settlement risk. Settlement risk mitigation may result in increased trading limits, as the proportion of any trading limit devoted to settlement risk for CLS eligible transactions effectively reduces to zero. TPs may benefit from the same credit efficiencies that many Settlement Members realize in the reduction of credit usage for CLS-settled trades. This has the effect of reducing credit allocation, allowing greater volumes and values to be traded. Date of issue: August

6 Operational Risk CLS works closely with technology vendors, business partners and regulators to ensure delivery of a robust and resilient infrastructure to its settlement service. The infrastructure provides Settlement Members and their TP customers with a catalyst for improving risk management and operations guidelines, allowing operational teams to focus on exception processing. CLS multilateral netting reduces the number of daily payment obligations per currency, thereby reducing the risk of late or erroneous payments. Fewer payments allow for more efficient processes, leading to streamlined Nostro reconciliations, and fewer late payments. 2.2 Liquidity Efficiencies Multilateral Netting Each day prior to settlement, CLS calculates the funding required of each Settlement Member on a multilaterally netted basis, taking into consideration all of its payment instructions that are due to settle that day. Multilateral netting reduces funding requirements by an average of 96%. This can be reduced further by using the In/Out Swap Service (an intraday swap consisting of two equal and opposite FX transactions). By combining multilateral netting and In/Out Swaps, funding requirements are reduced by an average of 99%. Settlement Members acting as TPSPs can in turn offer their TP customers the capability to pay and receive only their multilaterally netted position per CLS-eligible currency. The actual benefit obtainable by a TP is dependent on its trading pattern and its arrangements with its TPSP, but multilateral netting is recognized as offering significantly higher netting efficiencies than bilateral netting. Liquidity Management TPSPs apply credit lines and may offer intraday limits to their TP customers. They may require pre-funding of short positions and may charge for intraday liquidity. Issues to Consider Because CLS does not guarantee settlement, TPs must understand and manage the potential market and liquidity risks that might result from failure to settle. TPs must also be mindful of the risk they incur from their TPSP. Should a TPSP fail and its TP FX instructions not settle in CLS, TPs could incur credit and liquidity disruption in settling FX payments bilaterally with their counterparties outside CLS. In addition, participants must understand the implications of the daily funding and settlement cycle. The CLS service has a set of deadlines and currency closing times that apply to all Settlement Members, who apply their own cut-off times and service levels to their TPs. Date of issue: August

7 2.3 Operational and IT Efficiencies Operational efficiencies and cost savings through enhanced STP can be seen in both pre- and post-settlement activities. Pre-Settlement CLS enhances back-office solutions via STP and increased standardization of systems and processes. The service enables Settlement Members and their TPs to focus their resources on managing exceptions, e.g. ensuring that FX payment instructions are matched on a timely basis. CLS provides Settlement Members with real-time monitoring of the status of the instructions for each FX trade. Settlement Members may in turn provide this information to their TPs, enabling Operations staff to promptly investigate unmatched instructions. The CLS matching process and confirmation functionality are an important element of the CLS value proposition. Post-Settlement The CLS PvP model significantly reduces the amount of post-settlement workflow as failed payments and resulting compensation claims are reduced. As a result, there are potential financial savings in funding, overdraft charges, and interest expense, and fewer resources are required to investigate missing payments and interest claims. CLS has delivered its settlement service for more than ten years and is noted for its robust performance during the 2008 global financial crisis. 2.4 Business Growth Expanded Range of Counterparties The risk of loss of principal when settling an FX trade is mitigated by using CLS. As a result, a trading organization becoming a TP could benefit from being a more attractive counterparty to a large group of Settlement Members and TPs already participating in CLS. Increased Trading with Existing Counterparties Typically, Settlement Members credit risk departments allocate larger trading lines for counterparties that settle in CLS. This can result in an increase in the notional value of their FX trading with existing Settlement Members and TPs. An institution joining CLS as a TP could expect to increase its own credit limits with existing counterparties that also settle in CLS. Date of issue: August

8 Additional Trading Opportunities from new CLS Currencies CLS is committed to expanding the number of currencies eligible for CLS settlement. Its Currency Program is actively engaged with a number of central banks to progress this initiative and as new currencies are added, TPs will realize the same benefits as they do for existing CLS eligible currencies. Date of issue: August

9 3. How an Institution can participate as a Third Party Institutions (banks, NBFIs, corporates or funds) that trade in the instruments settled in CLS may use the CLS settlement service as a TP of a Settlement Member. Settlement Members process all payment instructions and funding on behalf of their TPs. The first step for any potential TP looking to join the CLS settlement service is to determine whether its custodian or clearing bank offers CLS settlement services. A non-exhaustive list of TPSPs is available on the CLS website: By providing TPs with indirect access to the CLS settlement service, Settlement Members become responsible for the payment instructions they submit to CLS on behalf of their TP customers. Each Settlement Member makes an independent credit and relationship assessment in deciding to whom it offers this service. CLS is not party to the contractual and commercial arrangements between Settlement Members and their TP customers. The following information is intended to help frame engagement by a potential TP with Settlement Members offering CLS third party services. Customer Support: Settlement Members vary in the way in which they provide support for implementation and on-going service. Many, but not all, have dedicated teams. Account Management and Service Offerings: The majority of TPs maintain CLS-dedicated accounts with their Settlement Members. TP services may be offered for all FX-related CLS products: spot, FX forwards, FX swaps and FX option exercises. Additionally, a Settlement Member may offer TP services for other CLS products, such as settlement of CLS eligible credit derivatives. Deal Submission, Cut-off Times and Reporting: FX instruction submission by a TP to its TPSP is normally via SWIFT. Subsequent reporting by the TPSP on deal status and cash flow may be via SWIFT, or, if there are appropriate message types, via the TPSP s proprietary services or through other media as arranged between the TP and the TPSP. Given the interconnected nature of the institutions with which it conducts business, CLS seeks to ensure that TPs and TPSPs do not pose any unnecessary risk to other participants of the CLS settlement system. For this reason, CLS Risk Management has established Best Practices to offer guidance to TPSPs and TPs: Date of issue: August

10 4. About CLS CLS mission statement To enhance financial stability by providing risk mitigation services to the global FX market CLS was established as a private sector initiative to deliver and operate a service to mitigate settlement risk in the FX market. As an Edge corporation organized and existing under the laws of the United States, CLS is supervised and regulated as a bank by the Board of Governors of the Federal Reserve System and the Federal Reserve Bank of New York. CLS also participates in a unique cooperative oversight arrangement with 22 central banks whose currencies are settled in CLS. CLS regularly meets with its Oversight Committee, which is chaired by the Federal Reserve. In July 2012 CLS was designated a systemically important financial market utility by the United States Financial Stability Oversight Council and has, as a consequence, significant dual public and private responsibilities. CLS Bank observes the Core Principles for Systemically Important Payment Systems published by the Bank for International Settlements (BIS) and, in due course, will comply with the Principles for financial market infrastructures 1 published by the BIS Committee on Payment and Settlement Systems and the Technical Committee of the International Organization of Securities Commissions. In September 2012, ACI -The Financial Markets Association issued its revised Model Code recommending institutions active in FX trading should be CLS participants where possible. 2 In February 2013, the Basel Committee on Banking Supervision noted A bank should use FMIs [financial market infrastructures] that provide PvP settlement to eliminate principal risk when settling FX transactions. 3 Who is Involved? The CLS ecosystem comprises the central banks of each eligible currency, Settlement Members (direct participants), TPs (indirect participants), and Nostro Agents. Software and technology providers may also be involved in the connection between a TP and its service provider. 1 For further information, see 2 ACI, The Model Code The International Code of Conduct and Practice for the Financial Markets. 3 Source: Supervisory guidance for managing risks associated with the settlement of foreign exchange transactions published by the Basel Committee on Banking Supervision. Date of issue: August

11 What Does CLS Do? CLS operates a global multi-currency system that provides payment-versus-payment settlement of the cash flows resulting from various types of FX transactions. The lifecycle of a payment instruction for a CLS-eligible FX trade by a Settlement Member or TP is shown below: The system is a unique combination of PvP settlement and the payment and receipt of multilaterally netted funding obligations over accounts CLS holds with participating central banks. These currency payments between CLS and its direct participants are executed through national real time gross settlement (RTGS) systems with finality. The service is supported by a robust and resilient infrastructure within a comprehensive legal and regulatory framework. Each day, Settlement Members submit payment instructions for their own or their TPs new FX trades to CLS. Matching typically takes place within 30 minutes of trade execution and Settlement Members are provided updated information on the status of these instructions (e.g. matched, unmatched etc.). Unmatched trade instructions are easily identified and resolved. Matched instructions are stored by CLS for subsequent processing on the value date. On the value date, CLS informs each Settlement Member of its multilaterally netted positions in the eligible currencies. The Settlement Member makes payments to CLS for those currencies in which it has a short position and receives payment from CLS for its long positions. Date of issue: August

12 Each Settlement Member is responsible for the exchange of payments between itself and each TP customer in respect of that customer s short and long positions. CLS settles payment instructions in FX spot, forwards, option exercises, and swaps in 17 currencies with over 60 Settlement Members from 23 countries. In addition, TP customers are based in over 80 countries. It is important to note that CLS does not guarantee the settlement of underlying transactions submitted by Settlement Members for their own proprietary transactions or the transactions of their TP customers. In the event that payment instructions are not matched or necessary funding and risk management requirements are not satisfied, the payment instruction will be rejected, thereby ensuring no loss of principal. In addition, because CLS does not guarantee settlement, participants need to fully understand and manage the potential market and liquidity risks that might result from failure to settle. Currencies Settled CLS settles payment instructions in the following currencies: Date of issue: August

13 The FX Market and Settlement Risk Settlement risk, also known as principal risk or Herstatt risk, is widely recognized as the most significant risk in the FX market. It is the risk that one party to a FX transaction will deliver the currency it sold, but not receive the currency it bought from its counterparty, resulting in the loss of principal. CLS operates a multi-currency cash settlement system through which settlement risk is mitigated. Given the size and systemic importance of the FX market, settlement risk mitigation is a high priority for central banks and other market participants 4. All members of the FX community potentially bear the risk of principal loss due to settlement risk. 4 Source: The Bank for International Settlements: Supervisory guidance for managing risks associated with the settlement of foreign exchange transactions, February 2013 Date of issue: August

14 Appendix Calculating the Potential Benefits of Participation The following two tables are intended to help a potential TP quantify the cost savings derived from using the CLS service. Each institution should analyze the potential cost savings from using the CLS settlement service by examining their actual costs incurred in settling outside CLS. The exact benefits may vary depending upon which TPSP is selected. CLS recommends that any institution undertaking this analysis do so for each currency on an individual basis, as funding costs will vary depending on the currency and/or the overall relationship with the correspondent bank involved. Table 1 illustrates comparative funding costs for trades settled outside CLS (either gross or through bilateral netting) versus inside CLS. Table 1: Calculation of Funding Costs Cost of Funding for settling outside CLS Cost of Funding for settling inside CLS Number of FX trades A A Average size of each trade B B Gross notional value of FX trades Netting efficiencies (e.g. bilateral netting) A x B = C A x B = C D % 96 % 5 Total amount of liquidity required C x (1-D%) = E C x (1-96% 6 ) = Y Funding cost per million F F Funding cost equation E x F = G Y x F = Z Total funding cost per day G Z Potential daily funding cost savings by using CLS = G Z 5 Source: CLS Risk Department - Average pre-in/out Swap netting efficiency for the period January June Source: CLS Risk Department - Average pre-in/out Swap netting efficiency for the period January June 2013 Date of issue: August

15 Table 2 compares operational costs for FX trades settled outside CLS versus inside CLS. It reflects the calculation of a per day total. The example illustrates potential sources of cost savings, both internal (e.g. investigation processes), and external, (e.g. Nostro charges and interest claims). Table 2: Calculation of Operational Charges Payments relating to FX trades settled Gross (i.e. outside CLS) Payments relating to multilaterally netted FX trades(i.e. inside CLS) 7 Cost per Payment K K Number of Payments L 15 Sub-Total K x L = M K x 15 = W Cost per Receipt N N Number of Receipts L 12 8 Sub-Total N x L = P N x 12 = X Cost of investigating late / nonpayments and late / nonreceipts (including staff headcount) Q Q Number of late / non-payments and late / non-receipts R? 9 Sub-Total Q x R = S Q x? = CC Average cost of interest claims in relation to late / nonpayments and/or penalties Number of interest claims in relation to late / non-payments T 0 U 0 Sub-Total T x U = V 0 Total of Operational Costs M + P + S + V = AA W + X + CC = BB Potential daily operational cost saving by using CLS = AA minus BB 7 The numbers for payments used in respect of CLS operational efficiencies are averages based on daily payments to CLS by existing Settlement Members since Sept 2002; i.e. a total average of 15 payments per day. A potential TP should, in liaison with its potential Settlement Member, analyze its own FX trading and settlement data to derive the likely number of multilaterally netted payments and receipts. 8 The average daily total number of payments that CLS has made to each Settlement Member since go-live in September CLS does not track payments between a TP and their service provider. Therefore, we suggest an institution liaise with prospective service providers to gain an understanding of what this figure may be. Date of issue: August