CLS: providing a solution or creating more headaches?

Continuous Linked Settlement is touted to eliminate settlement risk for foreign exchange transactions, but will it just create more problems?
The Continuous Linked Settlement (CLS) system, due to be implemented worldwide to reduce foreign currency settlement risk, presents fresh problems for central banks and markets that will take time to solve, says one banker who declined to be named.

Under the CLS system, member banks have to hold multicurrency accounts at the CLS Bank, which will settle trades by debiting the account of the seller for the currency and crediting that of the buyer. Settlement members will be allowed a "short position limit" in each currency and an "aggregate short position limit" across currencies. Both sides of each trade will settle simultaneously within each bank's "aggregate short position limit" to achieve a form of payment versus payment (PvP). Though settlement risk is reduced in this way, intra-day liquidity risk can be heightened by CLS, says the banker, who is working closely on the project.

Liquidity risks arise because five payment hours are scheduled and funding must be in place to reduce the pay-in requirement below the "short position limit" and "aggregate short position limit" by the second payment period at 9am central European time (CET), which is at the end of the business day for most Asian countries. Settlement member banks will have to bear the brunt of managing intra-day liquidity mismatches due to the pre-fund early in the day and the de-fund later in the day. This requires banks to exercise real time management of cash and also securities that enable central bank funds to be released when no cash is available. New tools will be needed to manage intra-day liquidity between real time gross settlement systems (RTGS) and CLS pools.

Joseph De Feo, chief executive officer of CLS Bank Services Ltd, at a press conference on Friday, assured that the CLS Bank has been developing tools to minimize the impact of any mismatched positions, and alternative sources of payment, should a bank miss a a pay-in.

Further, the implementation of CLS will necessitate changes to the process of foreign exchange processing, including the development of accounting policies that will mean front and back office systems have to differentiate between non-CLS and CLS trades.

For a start, says Geoff Armstrong, HSBC's head of institutional banking, Asia Pacific, banks will have to change internal systems so that multiple currencies can be handled. The degree to which a bank will have to revamp its systems will depend on the flexibility of the member bank's systems, he continued. Armstrong maintains that HSBC, one of the original founding shareholders of CLS, will be ready for the worldwide launch in October of this year. He added that HSBC's US dollar clearing system in Hong Kong will complement CLS.

In the event of a systems failure, the CLS Bank has estimated that $10 billion in liquidity will be at risk if not recycled. In a report by the the Committee on Payment and Settlement Systems (CPSS) of the central banks of the G10 countries, a bank's maximum foreign exchange settlement exposure could amount to three days' worth of trades at any point of time.

The CLS system also anticipates that there will be 100% participation by banks handling foreign exchange transactions. Intra-day real time settlements may be problematic for settlement members that do not have direct access to central banks, as the CLS Bank will link banks and the local RTGS systems operated by central banks. However, CLS's De Feo points out that membership was not restricted to the some 66 tier 1 banks and that third party members as well as fourth party participants should ensure the participation of sufficient liquidity in the system.

CLS history and future plans

The CLS bank is a private initiative that began in 1996 by the largest foreign exchange banks - the group of 20 (G20), to eliminate settlement risk and reduce the systemic liquidity risk in the foreign exchange market. Today the "banker's bank" has 66 member institutions, though the number may vary due to mergers and acquisitions in the global banking sector.

When launched in October, the system will initially support seven eligible currencies: the Australian, Canadian and US dollars, the euro, the Japanese yen, the Swiss franc and the UK pound sterling. According to De Feo, three Asia Pacific currencies will be added to the system by the end of 2002 or 2003. The currencies are the Hong Kong, Singaporean and New Zealand dollars.

So far, De Feo says, the cost of the project has been in excess of $200 million, a figure which he admits has exceeded initial expectations. When operational, the CLS project looks to capture 85% of global flows and 70,000 transactions on a daily basis. According to estimates by the Bank for International Settlements, the average daily turnover for global currencies in spot, outright forward and foreign exchange swap contracts is $1230 billion. Cross currency trading growth is estimated by the CLS Bank to have grown by 43% since 1995.

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