CLS GATHERS MOMENTUM

Indirani Rao*

There is no stopping an idea whose time has irrevocably in a five-hour window during
come. For 200 years the forex market was which trade funding, settlement, and
content with the traditional mode of payment are executed among participants
settlement of foreign currency trades in The central institution, CLS Bank, has links
disparate modes over different time zones. . with the real-time gross settlement (RTGS)
The Continuous Linked System which payment systems of 11 different currencies
sought to change this, replacing the process eligible to be settled over CLS and performs
with a payment-versus-payment (PVP) of the functions of a central clearing house.
mechanism, therefore, could not expect to It has 55 settlement members interfacing
have an easy time – and did not. The concept directly to the CLS network and over 170
spent a long time on the drawing board, third-party users which are institutions that
several factors delayed its launch, and clear and settle payments via the system
skeptics felt vindicated. It has been a full two indirectly, through correspondent banking
years now since Continuous Linked services provided by a settlement member.
Settlement (CLS), the real-time settlement The multilateral netting effect of settling
system for the global foreign exchange over 130,000 trades across CLS means that
market, went live. Today, CLS has taken the average net funding requirement drops
confident strides in the forex market, to almost two percent when the gross value in
settling about 130,000 transactions daily system rises above 1.5 trillion U.S. dollars.
with a gross value of $ 1.6 trillion. Well
Payments and funding of net positions in
ensconced in the inter-bank market, CLS
each currency take place over a 5-hour
now seeks new terrains.
window (07.00-12.00 CET). However,
What then is CLS all about? A prior issue of underlying trades are settled usually in two
the Rakshitra carried an article on the hours of the settlement cycle (by 09.00 CET),
subject. In brief, the CLS system facilitates because of short position limits given to
real-time settlement of the payments each member.
associated with currency trades among the
Short positions can be paid in on a member’s
world’s major trading institutions in the
behalf even if funds have not been received
foreign exchange market. Funds are settled

*Ms. Indirani Rao is the Vice President, Forex Settlement

The Clearing Corporation of India Limited.
from the member as long as it is within the fulfilling its primary mission of reducing
currency short position of that member. The settlement risk in the global foreign
long positions to be paid out to the member exchange market, the CLS system is a clear
are held to collateralize the short positions, success in also providing benefits in other
and are released once funds are received. This key areas of its participants’ foreign
process optimizes the use of funds, ensuring exchange businesses. Major benefits cited by
that funds in the account are recycled and all Members surveyed include reduced
trades settled. settlement risk, improved Straight through
Processing and operational efficiency gains.
CLS has achieved more than could have been
FX trades are being matched and settled in
hoped by the regulators that demanded its
less than 30 minutes; trade failures have been
creation. In early 2004, Tower Group, a
all but eliminated. The operational
leading financial research and consulting
performance of participants has been
firm, conducted its second annual CLS
enhanced substantially. Market practice is
survey, covering both settlement member
beginning to force the pace. CLS
and third-party participants in the CLS
counterparties are finding that membership
System. The purpose of this survey was to
has its privileges. Reuters trading
“gain insight into the value and benefits of
conversations are beginning to include
the system as perceived by its participants in
messages stating ‘This price CLS only’.
a variety of areas, including processing
According to Tower Group, 54 per cent of
volumes, system operations, and to evaluate
third-party CLS users have changed their
the indirect impact of CLS in the areas of
trading practices with counterparties, of
treasury services, credit operations, and
which 68 per cent said they favoured CLS
foreign exchange performance benchmarks.
counterparties and 47 per cent received
The survey projects the volume of foreign larger trading lines. A majority of the users
exchange trades to increase by more than reported reduced need for settlement limits
90% over current levels by the end of 2005. for CLS counterparties. Fifteen per cent of
The study also predicted that the volume of Members and 11% of third parties had
third party instructions would increase five- eliminated the need for limits completely.
fold by the end of 2006. Usage of CLS Bank
Improvements cited by Member treasury
by current users is also set to rise, with the
divisions specifically included the reduction
proportion of current Member respondents
in treasury payments, reduced compensation
settling over 50% of their daily value
claims and decreased funding requirements.
through CLS Bank predicted to rise from
Third party treasury divisions reported
60% now to 89% by the end of 2005. The
changes to liquidity management, improved
survey results clearly indicate that beyond
information on positions, management of
credit facilities and new or expanded reengineer their back office processes. Such
relationship with counterparties. CLS’s re-engineering entails costs although one
greatest impact has been a requirement to could argue that third-parties derive many of
time payments carefully, both as initiator of the benefits of CLS participation at lower
the forex trade and as the Nostro agent. Use costs than those incurred by the settlement
of CLS is changing how banks manage member. Technology spending to date by
liquidity and is also beginning to change third-party participants for implementing
their view of nostro providers and CLS is reported to be approximately US$
correspondent banking. Third party FX 18.1 million, or about US$140,000 per
operations also highlighted reduced error institution, substantially less than the
rates and exception management, improved aggregate US$335 million, or about US$6
reconciliation speed and reduced treasury million per institution, spent by settlement
payment volumes. members. Third-party participants’
spending is nearly evenly divided between
It is not all a path of roses, however. A few
external technology spending (on vendor-
banks do report an increase in nostro
supplied application software, integration
charges. The price of gaining the benefits
services, internal technology development,
that CLS can offer has been a slight increase
and hardware) and internal technology
in trade settlement costs. The median cost to
spending (on re-engineering back-office and
process an FX transaction has been reported
treasury systems, and on operations
to remain between US$5 and US$10 both
consolidation).
before and after implementation. Banks
which might have been settling deals at less Why the large spend? One needs to
than $2 per deal may see CLS as expensive. recognize that the processing of a CLS deal is
However, CLS charges need to be viewed in radically different from the processing of
the perspective of operational gains and risk other FX deals. Therefore, banks will have to
reduction. Reconciliation is far easier, and early on differentiate between deals that can
the average matching time in CLS is 30 be settled through CLS and deals that have to
minutes. Again, while most users cite be settled outside the CLS system depending
improved reconciliations, they also report on the currency and the counterparty.
increased working hours, particularly for the
CLS implementation involves simultaneous
purpose of more actively managing liquidity
altering of the settlement process in up to 11
and the timing of payments.
currencies for each counterparty. In
The average elapsed time for third parties to addition, new funding procedures need to be
begin testing was 6 months – indicating that established. Since settlement of trades at CLS
CLS Implementation does require banks to bank is on a gross basis and funding on a net
basis, member banks will have to suppress implemented.
individual payment messages to their
Now that CLS is firmly established as the
nostros, and instead settle the net obligation
settlement standard, it is trying to extend its
with the settlement member. Message format
reach. This is inevitable given CLS’s track
(MT300) of the confirmations will have to
record, but it is also essential. Participants
undergo changes to make it eligible for CLS
are finding it both difficult and expensive to
settlement. SWIFT has designed a new
run parallel systems to accommodate
service dedicated to support CLS trading
eligible and ineligible trades. New currencies
operations.
and new counterparties are continuing to
However it is not market practice to simply come on stream. CLS will be adding four new
begin trading through CLS. Individual bi- currencies, HKD, NZD, ZAR, and KRW to
lateral agreements will need to be made with its settlement process by the end of 2004.
each of the counterparties to include start
Where do we go from here? More profound
date of CLS trading, settlement instructions,
changes are afoot as CLS grows to industry
contact details for queries and any
standard status.
exceptions to CLS trading. In other words
the Member Bank needs to add new SSI The need to capture higher volumes is
(Standard Settlement Instruction) in their prompting calls for ‘extended sessions’ to
masters (system) and maintain these for all enable processing of a wider range of trades.
the CLS eligible currencies and CLS eligible One barrier to increasing volumes is the
Counterparties. The CLS community has system’s current five hour window. Allowing
worked to develop the CLS directory with additional trades to be settled after current
SSI Search. The directory reduces the efforts CLS-eligible deals are settled at 06:30 CET
and costs involved in static data would be a major step toward reducing
maintenance. liquidity swings as well as increasing
volumes. It has been our experience in the
Cash deals are not taken up by CLS for
Indian forex markets that while the actual
settlement and hence have to be settled by
percentage of cash and tom deals reported
member banks in the traditional way outside
for settlement may be less than 5-6% of the
CLS Bank. Existing forward trades are
total deals, volumes are about 20% of total
usually left outside of CLS and, if needed,
volumes. Typically, banks square up their
converted later. Converting counterparties
positions over cash on a spot basis and vice-
onto CLS is a gradual process. Most new
versa. CLS is working on an initiative to
Settlement Members and Third Parties wait
provide for inclusion of same-day trades
to contact their counterparts until after they
within the CLS process with an additional
are certain their CLS process is successfully
three-hour window.
Corporates and fund managers are customer banks. However, a significant
awakening to the possibility of improving proportion of the $1.2 trillion a day FX
the operational efficiency of their back market are transactions settled by custodian
offices and further enhancing STP levels. banks on behalf of investment fund
Corporates and fund managers may not c u s t o m e r s . To d a y m a n y F i n a n c i a l
have the same kind of volumes as third-party Institutions trade in securities denominated
banks, but an increasing number are looking in foreign currencies. The settlement of these
to CLS to help them achieve cost savings transactions requires an FX transaction, i.e.
through operational efficiencies. The main the custody related FX. In this process, the
benefits of CLS cited by settlement members Fund Manager enters FX contracts with a
such as reduced settlement risk; improved Broker on behalf of a Fund, and the
STP; reduced errors; improved access to CLS Custodian of the Fund is responsible for the
counterparties can be as important to non- settlement. The participation of three
banks as existing participants. There is a entities in the FX deal enhances the
clear cost saving opportunity through complexity of Custody-related FX. This
netting the transactions and virtually complexity translates into settlement and
eliminating exceptions management operational risks, which can be removed or
operations. In the CLS session at the SIBOS minimised by processing through CLS Bank.
2004 conference in Atlanta, the HP For Fund Managers the greatest advantages
representative stated that his firm’s first two lie in the simplification of the operations.
months as a CLS third party member had CLS not only takes away the settlement and
helped in reducing settlement risk and its cross-settlement risk, but also provides
daylight overdraft requirements. The automatic confirmation matching, making
representative from Refco Capital markets the current, largely manual, procedures
stressed that while the launch was less redundant.
dramatic than expected, the goals of a
CLS Bank estimates that Custody FX
streamlined back office, risk reduction and
represents around 20% of the global FX
ability to do business with firms which were
traffic and is growing rapidly with the
not willing to do so before for credit reasons
growth of the security market. The
were achievable. High profile corporates
enhancement enabling settlement of
such as Nike, the U.S. sports goods retailer,
custody FX will enable institutions to
and Swedish motor manufacturer Volvo are
achieve a higher level of straight through
among a number of firms that have
processing along with access to CLS’s risk
transferred FX settlement to CLS.
and credit reduction benefits.
CLS settles FX transactions executed
A CLS Working Group has started work on a
between settlement members or their
survey of settlement members to identify avoid being left out of the race. CCIL’s
foreign exchange instruments for which CLS proposal to offer CLS services to its member
could provide added value. The survey will banks has received a lot of interest both from
cover market settlement options for: banks in India as well as the CLS Bank itself.
Options, Non-Deliverable Forwards The model shows the way for banks to derive
(NDF’s), Derivatives including Interest Rate CLS benefits at much lower costs and with
Swaps and possibly services in non-eligible far more flexibility in funding than they
currencies and other instruments such as would otherwise enjoy.
money market.
References
It is quite evident from the foregoing that
Gt Newsletter, CLS Newsletter, ABN AMRO
CLS will define cross currency settlement
Best of CLS Update, CLS Newsletter,
standards and banks in India will need to
Bank of New York
gear up their systems to be in readiness to

CLS Summary
Commenced Live operations 9th September,2002
No of Settlement members 55
No of third and fourth party members 170
Instructions: 130,000
Gross value: $ 1.5 trillion
Average daily volumes
* Peak :
Instructions: 262,000
Gross value: $ 2.5 trillion
Total volumes settled since launch $ 500 trillion
Active Currencies 11 (SGD,AUD,JPY,EUR,GBP,CHF,NOK,SEK,SKKCAD,USD)
New Currencies in the pipeline 4 (HKD,KRW,ZAR and NZD)