CLS AND BILATERAL NETTING BETWEEN A ROCK AND A HARD PLACE. A White Paper by Wall Street Systems

Transcription

1 CLS AND BILATERAL NETTING BETWEEN A ROCK AND A HARD PLACE A White Paper by Wall Street Systems

2 CLS And BiLAterAL netting BetWeen A rock And A HArd PLACe Content Introduction 3 FX Settlement Risk 4 The Classic FX Settlement Risk Example 4 The Origins of CLS 4 Bilateral Netting 5 Conclusion 7 PAGE 2 OF 8 Edition 1

3 CLS And BiLAterAL netting BetWeen A rock And A HArd PLACe introduction With the subprime mortgage and credit crisis taking up everyone s attention, foreign exchange settlement risk has taken a back seat in both the headlines and the focus of financial market participants. There have been no major meltdowns, no spectacular headlines and no significant write-offs due to settlement risk issues. In fact, it s been decades since the last major FX settlement risk incident occurred. That being said, these are interesting times for the large global banks that dominate the FX trade flows and for CLS Bank International 1, the special purpose bank that is responsible for settling the vast majority of FX trades since it began operations in CLS has eliminated the settlement risk for nearly 60% of all FX trades that are currently settled worldwide and it supports the top 15 trading currencies very impressive numbers for an organization that has been in business for less than six years. There is, however, one issue that could derail the remarkable progress made by CLS over the years and that is how to deal with the increased pressure from its member banks to accept bilaterally netted FX trades. CLS and its member banks do not currently accept the payment messages from bilateral netted trades they only accept the individual trade tickets. However, as the market continues to develop there is a divergence between the participants in the FX market who want delivery of the currencies they have bought and those that don t. In the latter case (and these participants are predominantly prime brokerage customers of banks), they expect to exchange the P&L at the end of each trading day. This segment has grown quickly and these clients are pressuring their prime brokers to adopt practices that were developed in the equities markets over the last decade. It is a classic market development challenge for CLS and its members, and one that needs to be addressed sooner rather than later. If left unresolved, CLS and its members will find it nearly impossible to continue to fully participate in the market s impressive growth rate going forward. Acknowledgment 1 According to the BiS, daily CLS operations are carried out by two companies; settlement takes place on the books of CLS Bank international (CLSB) which is chartered by the Federal reserve and based in new York, but the actual processing is contracted out to CLS Services (CLSS), a company based in London. Both CLSB and CLSS are wholly owned by a Uk holding company (CLS Uk intermediate Holdings Ltd.), which in turn is wholly owned by CLS group Holdings, a holding company in Switzerland which currently has 70 financial institutions as shareholders. CLSB is supervised by the Federal reserve and governed by new York law. CLSS is overseen by the 15 central banks whose currencies are settled in CLS. this structure is designed to give CLSB the benefits of special insolvency protection under both United States and european Union law. PAGE 3 OF 8 Edition 1

4 CLS and Bilateral Netting Between a Rock and a Hard Place Acknowledgment 2 Optimizing Settlement Risk Management: CLS and Beyond. A White Paper by Wall Street Systems. Oct p Bank of Canada Review, Autumn CLS Bank: Managing Foreign Exchange Settlement Risk. P15. 4 In December 1997, CLS Services merged with two other initiatives already in existence, ECHO and Multinet. This allowed CLS Services to become the one dominant initiative to reduce risk in foreign exchange settlements. 5 According to the Bank for International Settlements, daily CLS operations are carried out by two companies; settlement takes place on the books of CLS Bank International (CLSB) which is chartered by the Federal Reserve and based in New York, but the actual processing is contracted out to CLS Services (CLSS), a company based in London. Both CLSB and CLSS are wholly owned by a UK holding company (CLS UK International Holdings Ltd.), which in turn is wholly owned by CLS Group Holdings, a holding company in Switzerland which currently has 71 financial institutions as shareholders. CLSB is supervised by the Federal Reserve and governed by New York law. CLSS is overseen by the (currently) 15 central banks whose currencies are settled in CLS. This structure is designed to give CLSB the benefits of special insolvency protection under both United States and European Union law. FX Settlement Risk Foreign exchange settlement risk the risk of a bank in a foreign exchange transaction paying the currency it sold without receiving the currency it bought is as old as the FX market itself and is one of the biggest concerns in today s international banking community. Any bank purchasing currency immediately risks the full amount of currency purchased from the time that payment instruction is confirmed and can no longer be cancelled unilaterally, until the time the currency purchased is received and the transaction is final. 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. The Classic FX Settlement Risk Example On 26 June 1974, the banking license of a German bank, Bankhaus Herstatt, was withdrawn by local regulator. 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. However, after the close of the German interbank payments system at 15:30 local time some of the bank s counterparties had paid Deutschmarks to the bank, believing that 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 earlier in the day. 2 The Origins of CLS CLS Bank dates back to a 1996 Bank for International Settlement (BIS) publication, Settlement Risk in Foreign Exchange Transactions (the Allsopp Report ) that advocated a strategy to eliminate settlement risk in FX transactions. The report identified three key settlement risk issues: Exposures that arise from foreign exchange settlement can extend over several days. At any given moment, the amount of risk to even a single counterparty may exceed a bank s capital. Foreign exchange settlement risk is a potential source of systemic risk. The report went to recommend a number of different strategies for minimizing and eliminating foreign exchange settlement risk. One of the key pieces of this strategy was for industry groups within the financial sector to develop a risk-proof, multi-currency settlement system that would establish a direct relationship between the payments of the two currencies involved in a foreign exchange transaction. 3 The Governors of the G10 central banks soon endorsed this strategy and in 1997, the largest global FX banks joined forces to create CLS Services a payment versus payment (PVP) settlement, (appropriately) named continuous linked settlement. 4 In September of 2002, after months of delays and having more than its fair share of sceptics, CLS Bank International began operations with 39 member banks and settled seven currencies. 5 Today, CLS settles on average more than $4 trillion each day in FX-related payment obligations in fifteen different currencies, representing almost 58% of FX trade flows worldwide. There are 60 CLS Bank Members and a total of 2,411 participants currently using the service. Included in this total are 373 banks, corporates and non-bank financial institutions and a further 2,038 investment funds. PAGE OF 8 Edition 1

5 CLS and Bilateral Netting Between a Rock and a Hard Place So how exactly does CLS work? For FX trades, CLS acts as a trusted third party between the two counterparties. What this means is that CLS is the settlement institution but does not act as a central counterparty the trades remain the obligations of counterparties themselves. And CLS does not actually settle the trades, but rather, they settle the payment instructions arising from the trade. 6 Each CLS member 7 has a multicurrency account with CLS. When a trade is submitted, the accounts of the two relevant members are simultaneously debited by the amount of the currency being sold and credited by the amount of the currency being bought payment versus payment (or PVP). Settlement of a trade takes place only if both parties to the trade meet all of the CLS risk controls including retaining an overall positive balance on both their accounts. After CLS calculates all trades that are due to settle for the day, members will have either a multi-lateral net long or short position in each currency. If a member has a net short position in a currency, a payment will be made to CLS Bank International, which CLS uses to make payments to members with net long positions. 8 Acknowledgment 6 Bank for International Settlements, Progress in Reducing Foreign Exchange Settlement Risk, July p According to the Bank of Canada, Financial institutions can participate in the CLS Bank in three ways: as settlement members, user members, or third-party users. But only settlement members can hold settlement accounts at the CLS Bank. User members and third-party users access the system through a settlement member, and their obligations are settled through the settlement member s account. 8 Bank for International Settlements, Progress in Reducing Foreign Exchange Settlement Risk, July p Ibid. 10 Bank for International Settlements, Progress in Reducing Foreign Exchange Settlement Risk, July p. 9. A pay-in-failure occurs when, for any reason, a member fails to meet its obligations to pay. If this occurs, then principal risk to the counterparty is avoided because CLS can return to that counterparty the value of the currency it is selling. CLS is also well-equipped to reduce liquidity risk in these circumstances because of standing liquidity facilities with large banks. If needed, CLS can, in effect, convert the currency the counterparty is selling into the one it is trying to buy despite the original member s pay-in failure. The value returned to the counterparty will thus generally be in the currency it was buying. 9 Bilateral Netting One alternative to the CLS model of settling trades is bilateral netting. Whereas CLS uses essentially a multi-lateral netting model to compute each participant s funding obligations, bilateral netting only takes place between two parties. In bilateral netting, banks must agree and draw up a separate contract with each counterparty a single legal obligation that defines which transactions are included in the agreement. For trades that are covered in a bilateral netting agreement, banks then only exchange the difference between what each party owes the other. In the event of a default or insolvency of one of the parties, their obligation is only the net sum of all positive and negative fair values of contracts included in the bilateral netting agreement. Prior to CLS starting its service there were thousands of these netting agreements in place. Even though most were dropped after the member banks agreed to the gross or individual trade model, it is estimated that that eight percent of today s global FX trade volume is still settled using bilateral netting. Bilateral netting is advantageous for banks when they need to process a high number of trades with the same counterparty. In this case, suppose Bank A enters into 10,000 daily FX trades with Counterparty B using the same currency pair. If Bank A used the CLS model to settle, then 10,000 different trade messages would be sent to CLS for processing. If bilateral netting was used, then the 10,000 trades would be netted internally with only one payment message needed. With the hedge fund/platform driven rise in FX trade volumes over the past three years, one can easily see the allure that bilateral netting has in the high volume trading segment. 10 In their quest to lower settlement costs, some banks perceive bilateral netting as a cost efficient way to mitigate volume growth pains. The conventional wisdom here is that the reduced messaging requirement and lower settlement volumes are a safe way for banks to cope with the increased trade volumes. PAGE OF 8 Edition 1

6 CLS and Bilateral Netting Between a Rock and a Hard Place Acknowledgment 11 According to the BIS, in corresponding banking, each counterparty to an FX trade transfers to the other counterparty the currency it is selling, typically using correspondent banks in the currencies concerned. Because the transfer of the sold currency typically takes place independently of the transfer of the bought currency, this method exposes the counterparties to principal and liquidity risks of the full value of the trade. There are, however, many in the marketplace (including those from CLS) who would disagree. They feel that multi-lateral netting is fundamentally more efficient at reducing funding versus bilateral netting, and that the claimed efficiencies gained from bilateral netting are unproven. The argument here is that even though bilateral netting reduces exposures, those netted obligations still need to be settled. And because CLS does not accept these netted payment messages, the normal settlement process for bilaterally netted trades uses traditional correspondent banking, complete with the same inherent settlement risk issues that prompted central banks to develop the CLS framework in the first place 11. They strongly believe that the use of bilateral netting poses higher operational risks. All this prompts the most obvious question: Why can t the marketplace take perhaps the best of both worlds and allow for CLS to accept payment messages from their member for bilaterally netted trades? First of all, there are major pricing model issues. Accepting netted payment messages would be a significant departure from the existing CLS pricing model a cost per trade model that is necessary to generate sufficient revenue to cover its regulatory imposed fixed costs. This model is based on consistent (and predictable) flows that allow for more efficient operations. With netting, the results are not so predictable (given the inconsistent trading patterns associated with some of the high volume algorithmic players) which would lead to inconsistent flows between counterparties on a day-to-day basis resulting in higher operational risk. Additionally, the opportunity to net flows is not equally distributed across the participants. Some member banks are significant users of bilateral netting and others are not. One solution to this might be for CLS to use a two-tiered pricing model (one for members who net, and one for those who don t). Unfortunately, this solution is neither clean (even the heaviest uses of bilateral netting would still have a majority of their trades flow in CLS as deal tickets), nor practical (member banks have on many occasions refused to change the existing model). Another alternative to the current pricing model might be for CLS to scrap its volume-based pricing model into one that generates revenue by charging set fees from its members. This would seemingly allow for a cleaner, more equal solution for the member banks. Unfortunately, seeking equality is not a factor for a number of these banks. Many view their capacity to process high volume trades as a competitive advantage. These banks have been able to retain this competitive edge by investing heavily in their infrastructure, many without having to resort to the use of bilateral netting. It will be these same banks who will fight hardest to keep the status quo in terms of the existing pricing model. They will be very reluctant to endorse any change in the model that might result in any kind of erosion of this competitive high volume processing advantage. The second major issue is even stickier and much more serious. Accepting netted payment messages could actually weaken the existing risk procedures already in place. Given the regulatory pressure that exists today, CLS and its member banks are very reluctant to make any changes that may have negative consequences in their overall mission of eliminating FX settlement risk. Some question the effectiveness of the underlying netting agreements, but the concern is far more comprehensive. According to Jonathan Butterfield of CLS, Effective or legally enforceable netting agreements are available. The issue then becomes how to manage and retain control over these agreements operationally on a daily basis at low cost. There is then the question of how to settle the net outcome which can still be for very high value on peak days. The sum of these alternatives has not, yet, persuaded our members to vote to change. If that changes, then obviously so will CLS. PAGE OF 8 Edition 1

7 CLS and Bilateral Netting Between a Rock and a Hard Place CONCLUSION BETWEEN A ROCK AND A HARD PLACE The bilateral netting issue comes down to this: As FX trade volumes rise exponentially in important segments of the market, some member banks are facing unrelenting pressure to efficiently and cost effectively deal with volume growth, including settlement without increasing risk. The increased use of bilateral netting seems to offer hope in achieving that goal, but only if the payment messages from those netted trades can be settled in CLS. The pressure CLS faces are from different factions within its members and the central banks that oversee its operations. Some member banks are challenging CLS to find a pricing model solution that would allow them to accept both individual deals and netted payment messages to respond to the different segments. Others are pleased with the STP gains made and don t believe netting is the answer. It s an industry issue of how to deal with a divergent set of customers with differing trading and execution models. Volume growth is one factor. Sophisticated platforms and trading models mean that volatility now produces extreme variations in daily trading volumes. This is a new challenge for the FX market. Major trading banks have a wide range of inputs to process FX trades from branch orders, through brokers, to algorithmic driven trades, and from multiple trading venues including their own. This suggests that a more fundamental review of the entire post trade processing chain, up to and including settlement, needs to be undertaken. There are subtle but significant differences between banks on the sequencing of the necessary steps to execute a simple spot trade. The new pressure is to provide extreme capacity at minimal cost. Whatever happens in the netting debate, residual or gross settlements will need to be made in a risk free manner. Forgetting this last step is not an option from a regulatory standpoint given the values to be exchanged. The process of navigating these changes and how to change the CLS operating model has a way to go before being finalized. PAGE OF 8 Edition 1

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