Next > Mitigating Risk and Enhancing Financial Stability in the Global FX Market
Reducing Risk in the Global FX Market Mission Statement: To enhance financial stability by providing risk mitigation services to the global FX market. CLS plays a fundamental role in the FX market. Owned by the world s leading financial institutions, it operates the largest multicurrency cash settlement system to mitigate settlement risk for the FX transactions of its Members and their customers. This is achieved through the provision of CLS unique payment-versus-payment (PvP) settlement service which has links to the real time gross settlement (RTGS) systems of the 17 currencies eligible for settlement in CLS. The FX market is a key part of global economic activity. It is the largest financial market by value and is integral to global commerce. The reasons for exchanging currencies are as diverse as the community who trade them. All members of the FX community potentially bear the risk of loss of principal due to settlement risk. Settlement risk is widely recognized as the most significant systemic risk to participants in the FX market, making its mitigation a high priority for the community as a whole. By effectively mitigating this risk for its Members and their customers, CLS plays a critical role in ensuring the smooth running of the FX market and providing stability to broader financial markets. The importance of which is further underscored by CLS designation as a systemically important financial market utility (FMU) 1. Front cover clock: Greenwich Shepherd Gate Clock United Kingdom, 1852 The first to display Greenwich Mean Time to the public. 1 Designated by the Financial Stability Oversight Council, the financial regulator created as part of the Dodd-Frank Wall Street Reform and Consumer Protection Act 2010. 1
The Evolution of CLS The impetus behind the creation of CLS came from regulatory concerns regarding the potential for FX settlement risk to be a major source of systemic risk. CLS was established as a private sector initiative to deliver and operate a service to mitigate settlement risk in the FX market. In 2002, CLS was launched with seven currencies and 39 Members. Since then, the CLS community has grown significantly and now includes 17 currencies, over 60 members and thousands of third party participants. CLS unique position within the FX industry enables it to work closely with market participants to develop, adapt and extend its settlement services in response to evolving market requirements. For example, the partnership with the Depository Trust and Clearing Corporation (DTCC) for the OTC market and the introduction of the trade compression service, CLS Aggregation, with Traiana. As the infrastructure that supports the FX market, CLS continues to deliver the settlement service, even during times of severe market stress. The economic uncertainty during the financial crisis of 2008 proved a defining moment for CLS. Despite periods of extreme volatility and deteriorating market sentiment, CLS delivered the settlement service without any failures and the FX market continued to function without disruption. Settlement Risk (also known as Principal Risk) Settlement of FX transactions requires the exchange of principal in two currencies. Settlement or principal risk is the risk that one party to a FX transaction will deliver the currency it sold, but not receive the bought currency from its counterparty, resulting in the loss of principal. It is also known as Herstatt Risk, a name derived from the failure of a privately owned German bank Bankhaus Herstatt. In June 1974, the bank s license was withdrawn by regulators which forced it into liquidation. Time zone differences meant that Bankhaus Herstatt had ceased operations after receiving DEM payments but before it released its USD payments, resulting in a significant loss of principal 2. 2 More information can be found in BIS: Bank Failures in Mature Economies, BCBS Working Papers No. 13, April 2004. Caesium Atomic Clock, National Physical Laboratory, United Kingdom, 1955 The first accurate atomic clock which led to the internationally agreed definition of the second. This second has an accuracy of one second in 15 million years. Since launch, CLS has settled over USD 7,700 trillion 2 Mitigating Risk and Enhancing Financial Stability in the Global FX Market 3
The Evolution of CLS June 1974 Bankhaus Herstatt fails 1970s March 1996 Committee on Payment and Settlement Systems (CPSS) publishes a report: Settlement Risk In Foreign Exchange Transactions (the Allsopp Report) a strategy for addressing FX settlement risk September 2002 CLS launched 39 Members and seven currencies (Australian Dollar, Canadian Dollar, Euro, Japanese Yen, Swiss Franc, UK Pound, US Dollar) February 2004 First FX transaction settled for a fund counterparty investment management community begin using CLS December 2004 Four more currencies added Hong Kong Dollar, Korean Won, New Zealand Dollar, South African Rand March 2008 CLS settles USD 10.3 trillion in one day a record value for the service September 2008 As conditions deteriorated in the global capital markets following the collapse of Lehman Brothers, CLS delivered the settlement service and the FX market continued to function without disruption May 2010 Period of market volatility, CLS settles an average of over one million payment instructions per day with an average daily value of USD 4.2 trillion September 2011 Record volume day: 1,960,492 payment instructions settled in one day September 2012 CLS celebrates its 10 year Anniversary 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 July 2012 CLS designated a systemically important FMU September 2012 ACI Model Code 3 recommends Institutions active in FX trading should be CLS participants where possible. 1990s September 2003 Four more currencies added Danish Krone, Norwegian Krone, Singapore Dollar and Swedish Krona December 2007 Settlement extended for certain over-thecounter (OTC) credit derivatives through a partnership between the DTCC and CLS May 2008 CPSS publishes a report on settlement risk, which renews the focus on settlement risk reduction, commends the CLS PvP architecture and provides steps to further mitigate settlement risk January 2010 CLS Aggregation launched to address the capacity challenges faced by banks resulting from the growth in FX trading from hedge funds, algorithmic traders, retail and institutional clients 2000s May 2008 Israeli Shekel and Mexican Peso added bringing the total number of currencies settled by CLS up to 17 For over 10 years, CLS has settled FX transactions with finality 3 ACI, The Model Code - The International Code of Conduct and Practice for the Financial Markets, September 2012. Cosmo Clock, Yokahama, Japan, 1989 Part clock, part giant ferris wheel. The world s largest clock. 4 Mitigating Risk and Enhancing Financial Stability in the Global FX Market
A Global Community Critical Infrastructure CLS settles payment instructions relating to FX trades in 17 currencies, which account for 94%4 of the total daily value of currencies traded globally. CLS role as a critical infrastructure puts it at the center of the FX industry. The CLS community involves a global network of central banks, commercial banks, investment firms, corporates and fund managers. CLS provides settlement services to participants both directly (for Settlement Members) and indirectly (through Settlement Members providing third party access to their customers). CLS works closely with technology vendors, business partners and regulators to ensure delivery of robust and resilient settlement services. Australian Dollar Canadian Dollar Danish Krone Euro Vendors SWIFT (provide connectivity between Settlement Members and CLS) (network and messaging standards) Oversight Committee of 22 central banks Service Delivery and Development Partners 17 RTGS Systems Hong Kong Dollar Israeli Shekel Japanese Yen Korean Won Mexican Peso New Zealand Dollar Norwegian Krone Singapore Dollar Nostros South African Rand Members Liquidity Providers Swedish Krona Swiss Franc UK Pound US Dollar Third Parties CLS is connected to 17 RTGS systems globally, between CET 07.00 and 10.00 4 BIS Triennial Central Bank Survey FX and derivatives market activity in April 2010 (September 2010). 6 Mitigating Risk and Enhancing Financial Stability in the Global FX Market 7
Benefits In addition to mitigating settlement risk, there are a number of unique benefits for both direct (Settlement Members) and indirect (third parties) participants that join CLS. Mitigating global FX settlement risk Efficient liquidity management Efficient credit line management Expanded range of counterparties Payment efficiencies through enhanced Straight Through Processing (STP) Huygen Pendulum Clock, Netherlands, 1657 A breakthrough in timekeeping through the discovery of the center of oscillation and its reciprocal relationship with the pivot point of the pendulum. Potential for new third party or nostro business Transparent and standardized processes and confirmations Benefits for Settlement Members Liquidity efficiencies through the multilateral payment netting provided by CLS the amount of cash required by CLS to settle all payment instructions is reduced by an average of 96% (before In/Out Swaps 5 ) Operational and IT efficiencies through standardization and enhanced STP Participation in a unique financial market infrastructure at the center of the FX market which creates opportunities for dialog across the community Business growth and new revenue opportunities through increased trading capacity, the opportunity to offer third party CLS services and FX Prime Brokerage to customers, and the provision of nostro services Higher standards all Settlement Members enter into identical Agreements with CLS and operate under a defined set of the Rules. Adoption of best practices, business continuity processes and resiliency promotes higher standards Benefits for Third Parties Operational and IT efficiencies and cost savings through enhanced STP»Reduced» errors Reduced number of settlements More efficient allocation of monetary and physical resources Improved liquidity management through the reduced number and amount of payments resulting from multilateral payment netting Business growth through increased trading capacity and credit availability Today, on average USD 14.5 billion is paid each day into CLS between CET 06.30 and 07.05 5 The In/Out Swap Service is designed to reduce the payment obligations to CLS and to mitigate liquidity pressures. An In/Out Swap is an intraday swap consisting of two equal and opposite FX transactions that are agreed as an intraday swap. On average, In/Out Swaps reduce payment obligations in CLS by 75%, translating to a funding requirement in CLS of less than 1% of the total gross settlement value. 8 Mitigating Risk and Enhancing Financial Stability in the Global FX Market 9
How the CLS Settlement System Works Following a FX trade, Settlement Members submit payment instructions to CLS. These payment instructions are then authenticated and matched by CLS and stored in the system until the settlement date. The CLS daily settlement cycle operates with settlement and funding occurring during a five-hour window when RTGS systems in the CLS settlement currency jurisdictions are open and able to make and receive payments. This enables simultaneous settlement of the payments on both sides of a FX transaction. Each Settlement Member holds a single multicurrency account with CLS. At the start and end of a normal settlement day, each Settlement Member has a zero balance on its account. Under normal operations of the settlement service, CLS starts and ends the day with a zero balance in its central bank accounts and in its Settlement Member accounts. Settlement Members may submit payment instructions relating to their own FX transactions, as well as the FX transactions of their third party customers, directly to CLS. On each settlement date, CLS simultaneously settles each pair of matched payment instructions by making the corresponding debit and credit entries across Settlement Members accounts at CLS. The settlement of the payment instructions and the associated payments are final across CLS books. This finality is one of the most important elements of the CLS system. CLS settles on average between USD 4.5 trillion and USD 5 trillion every working day, 99% of all payment instructions are settled between CET 07.05 and 07.50 FX Contracts CLS Member or client trade trade agreed CLS Member or client trade CLS payment instruction* CLS system CLS payment instruction* Payment instructions matched Payment instructions stored until settlement date Funding (via RTGS systems) Payment instructions settled on settlement date (contractual obligation extinguished) Funding (via RTGS systems) *Mandatory SWIFT standards Pay-in and pay-outs from/to Settlement Members either direct of via nostro Grand Central Station, New York, USA, 1913 The compass in the small point at the top correlates with the true north direction with 100% accuracy. 10 Mitigating Risk and Enhancing Financial Stability in the Global FX Market 11
Effective Financial Systems Depend on Safe and Efficient Payment Systems Greenwich Shepherd Gate Clock United Kingdom, 1852 The first to display Greenwich Mean Time to the public. A well-managed payment system minimizes the effects of economic disturbances that could otherwise disrupt domestic and international financial markets. Recognizing its role as a critical infrastructure at the center of the FX market, performance, resilience and security are all of paramount importance to CLS. A real-time secure global system able to flex to meet the demands of an evolving market Mirrored environments in multiple data centers to deliver the highest levels of resilience and business continuity A standard legal framework for settlement finality A comprehensive regulatory framework: CLS is supervised and regulated by the Federal Reserve Bank of New York CLS is subject to a unique cooperative oversight arrangement with the central banks whose currencies are settled in CLS (Oversight Committee) A robust governance structure combining an appropriate level of flexibility with high standards of business transparency, accountability and independence Compliance with the Core Principles for Systemically Important Payment Systems 6 which provides guidelines for the design and operation of safer and more efficient systemically important payment systems Compliance with the Interagency Paper on Sound Practices to Strengthen the Resilience of the US Financial System 7 which recommends reliance upon dual data centers with synchronous data replication 6 The Core Principles for Systemically Important Payment Systems was published by the Committee on Payment and Settlement Systems (CPSS) in 2001. In April 2012, the CPSS and the Technical Committee of the International Organization of Securities Commissions (IOSCO) published: Principles for Financial Market Infrastructures. It replaced the previously published Core Principles. CLS is currently working to attain these new standards. 7 The Interagency Paper on Sound Practices to Strengthen the Resilience of the US Financial System was jointly published by the Board of Governors of the Federal Reserve, the Office of the Comptroller of the Currency and the Securities and Exchange Commission in the United States in April 2003. 12 Mitigating Risk and Enhancing Financial Stability in the Global FX Market
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