There has been considerable interest in CLS since its much-anticipated launch in late 2002. This is hardly surprising, as CLS provides a groundbreaking settlement mechanism that significantly reduces the settlement risk in the global FX markets, where the daily turnover in global FX transactions currently averages $2 trillion and continues to grow at an exponential rate.
By March 2004, over 120 third parties had joined the CLS system. Over 90% of these are from countries whose currencies are CLS eligible. Presently, FX trades comprising the following eleven currency pairs are eligible for settlement on CLS: Australian Dollar, Canadian Dollar, Danish Krone, Euro, GB Pound, Japanese Yen, Norwegian Krone, Singapore Dollar, Swedish Krona, Swiss Franc and U.S. Dollar. The Hong Kong Dollar is expected to join by the end of 2004.
Where is the interest?
OECD banks have been leading the way in CLS settlement because of the sheer weight of their CLS eligible activity. However, the take-up rate by European/US institutions is now slowing down, as the early adopters have already implemented CLS into their back offices. What we are seeing now - and increasingly so since the turn of the year - is an upsurge in interest from potential third parties in the emerging markets.
While there has always been a high level of interest from these banks, the prevailing attitude has been predominantly one of 'wait and see'. Increasingly, as these banks recognise that there are compelling business benefits for taking up CLS, the 'wait and see' is moving strongly towards 'commit and implement'.
Why would a bank join CLS as a Third Party?
Even with relatively low volumes of eligible trades, there are compelling reasons for joining CLS as a third party:
For a bank wishing to realise the benefits of CLS settlement, third party participation is by far the most cost-effective means of achieving this. As for the substantial initial investment involved, settlement banks have already undertaken both the shareholding and systems investment and Third Parties do not need to incur that cost.
New Business Opportunities
The risk reduction element of CLS now means that banks would have more counterparties, and be able to trade higher volumes. This greater liquidity or depth in the market will improve opportunities - and profitability for those banks.
This is win-win situation for both third parties and their settlement banks.
At an industry level, increased volume in the system lowers the unit pricing - not only for an individual bank but for the banking community as a whole as costs are shared over a wider base. At the same time, banks will be able to realise risk reduction - the key driver behind CLS. And lastly, but by no means least, CLS provides a unique opportunity for settlement banks to deepen their relationships with their third party customers.
Efficiency and Risk Management:
The efficiency and risk mitigation benefits of CLS would undoubtedly be a key consideration for banks joining CLS.
How Much Change is Really Required?
Despite the manifest benefits of joining CLS, some banks regard the systems and operational change required as a major disincentive to implementation.
But just how much change is actually necessary? While both systems (technology) and operational changes would be required, the scale of those changes will be determined by the third party's own current systems configuration. Simplistically, at one extreme if the process is entirely manual, then the changes are to operations and procedures. At the other extreme, a fully automated process will require some systems change - but little in the operational area. Furthermore, CLS operates on SWIFT messaging, and that is familiar to all banks. No new hardware is required, and broadly the same message types are used. Wrapping the necessary changes that joining CLS entails into the bank's existing change-management programme can often be a cost -effective means of managing it. The idea of change is often daunting - but the reality may be a great deal simpler.
What qualities would a Third Party want in a Settlement Bank?
Much depends on the overall relationship that a third party may have with its potential providers, but there are certain essential qualities:
Global transaction capabilities - whilst not necessarily clearing in every CLS currency, the settlement bank must be a global player in clearing and settlement, and clearly committed to the business.
Capability - both in terms of product functionality, customer service, liquidity and credit capability, a settlement bank needs to be able to demonstrate it can serve its customers with a proposition that gives all the functionality and service required - at the right price.
Implementation - whilst the implementation need not be complex, it must be managed efficiently, and as far as possible, locally. Settlement banks need to demonstrate a proven ability to manage an infrastructure development with customers.
How far have we come, and what lies on the horizon?
The Singapore Dollar joined CLS in September 2003, and this year, three more Asia-Pacific currencies are expected to join, namely Hong Kong Dollar, Korean Won and the New Zealand Dollar. This is likely to promote activity more widely across the Region, as other countries also seek to have their currencies become "CLS eligible". We can look forward to an increasing number of banks making the commitment to join CLS. The increasing focus on the Asia Pacific was most recently highlighted at the CLS company's Third Party Seminar in Hong Kong in February 2004.
In the eighteen months since it went 'live', experience with CLS has been extremely positive. The expected benefits of risk reduction and increasing efficiency are being realised, with settlement banks themselves putting through as much of their own volume globally as possible, and encouraging counterparties and customer banks to adopt CLS. As the number of banks and institutions using CLS grows over the years, so too will the transaction volumes. Its success in managing FX settlement risk certainly confirms CLS as the industry settlement standard.
Says Jaspal Bindra, Standard Chartered's Global Head of Client Relationships, Wholesale Banking, "CLS is an invaluable as a risk management mechanism, and will become increasingly entrenched as the industry standard for settlement of foreign currency transactions as more currencies and counterparties join the system over time."
CLS offers risk reduction in forex settlement, allowing a wider number of trading counterparties, and more liquidity in trading, as well as a greater certainty - and therefore efficiency - in Cash Management of nostro balances in all the CLS currencies.
Although the majority of banks in Asia are not settlement banks, they too can benefit greatly from the CLS system through the Third Party offering provided by Settlement Banks, which provides a viable alternative for them to achieve the full benefits of CLS settlement
Bernard Valvona is a Senior Manager, Global Financial Institutions Group, Standard Chartered