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Continuous Linked Settlement (CLS): Then and Now (Including a snapshot of the BIS Triennial Central Survey 2013)

Seema Ganapathy*

CLS - Growth story: Owned by 77 of the world's leading financial institutions, CLS plays a fundamental role in the The currency markets are the largest and most FX market - it operates the largest multicurrency liquid markets in the world with an estimated cash settlement system to mitigate settlement $5.3 trillion changing hands each day (BIS risk for the FX transactions of its Members and Triennialsurvey 2013). Steering this large, mostly their customers. The CLS system facilitates real volatile market that straddles most of the time settlement of the payments associated with countries across the globe into safer waters is a currency trades among the world's major trading fairly unknown entity called the CLS Bank. institutions in the foreign exchange markets on a Continuous Linked Settlement (CLS) is one of payment versus payment mechanism. the eight financial market utilities in the world - Instructions from counterparties to an FX trade entities that engage in risk management activities are authenticated, matched and settled on an such as and settlement to have been agreed date in 17 currencies. designated as systematically important by the US Financial Stability Oversight Council (FSOC). Funds are settled irrevocably in a 5 hour window during which trade funding, settlement and CLS was launched in 2002 with 39 direct payment are executed among participants. The participants and 7 currencies to eliminate Central institution, CLS Bank, has links with the settlement risk, one of the biggest dangers in the real time gross settlement RTGSpayment systems FX markets. Today,it has 64 settlement members of 17 currencies eligible to be settled over CLS interfacing directly with the CLS Network and and performs the functions of a clearing house over 11,000 third party users which are settlement. In order for this to happen, RTGS institutions that clear and settle payments via the timings of some currencies have been extended system indirectly through correspondent to ensure they overlap across time zones. banking services provided by a settlement member. December 2014

Ms. Seema Ganapathy is Manager, Forex Settlement Department CCIL Monthly Newsletter The Clearing Corporation of India Limited

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Central European Time (CET/CEST)

Settlement In/Out Swaps Funding: Pay-ins & pay-outs

00:00 07:00 10:00 12:00 Initial Start of funding End of funding End of funding Pay-in schedule and settlement (Asia/Pacific) (Other currencies)

06:30 09:00 Revised End of Settlement Pay-in schedule (target)

CLS Summary

Commenced Live operations 9th Sept 2002 62 settlement members No of direct participants 2 User Members No of indirect participants (third & fourth 11000+ parties) Average daily volume USD 5.94 trillion (Sept 2014 figures) NZD, JPY, AUD, HKD, SGD, KRW, DKK, SEK, CHF, ILS, ZAR, MXN, EUR, Active currencies (17) GBP, NOK, USD & CAD New currencies in the pipeline Brazilian real, , Chinese Yuan, Russian ruble and Thai baht

CLS -Epitome of efficiency in times of stability and transparency CLS provided, financial crisis Lehman's failure did not severely disrupt the market, as was the case with . CLS The biggest testament to the success of CLS is had done its job. The European , in seen in its performance during the Lehman crisis. a March 2009 report analyzing the operational Post the Lehman Brothers collapse in 2008, when December 2014 lessons from Lehman's demise, found that, “at many markets were run aground, CLS was able to the end of the day, CLS proved that it effectively ensure that forex markets continued to function offsets the problems it was designed for, i.e. to smoothly. CLS was created specifically to prevent prevent a systemic crash by removing principal cross-currency settlement risk (also known as risk (the so-called Herstatt risk).” The report Herstatt risk, after the German bank whose further concluded: “The Lehman downfall failure in June 1974 led to massive FX trading proved that CLS is an effective measure to CCIL Monthly Newsletter losses at its counterparties). Because of the mitigate settlement risk.”

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CLS Key Considerations: transaction life cycle, bringing consistency and efficiency to the risk management process. 1. Eliminating settlement risk 5. Enhances treasury functions CLS addresses settlement risk through a payment versus payment (PVP) process. Each of the two CLS's same-day funding cycle greatly reduces the parties to an FX trade pays out one currency and cash outlays required to complete settlements. In receives another simultaneously, thus avoiding addition, multilateral netting reduces the the possibility that an institution pays out funds number and amount of payments that must be without receiving reciprocal funds due. In effect, made. As settlement is virtually guaranteed, this CLS eliminates settlement risk in FX, the world's gives treasury groups earlier notification and single largest financial market. confidence with their intra-day credit lines. The end-of-day reconciliation process for the bank's 2. Greater operational efficiency trades also becomes more efficient as they are no In addition to removing settlement risk, CLS longer reliant on an individual payment to settle offers a number of operational and liquidity a single trade. benefits, leading to significant cost savings. For 6. Trading with more counterparties example, CLS members base their daily funding requirements on a multilateral net position, The CLS process encourages trading with rather than gross transaction-by-transaction additional counterparties and may lead to funding, which reduce necessary daily funding consider counterparties that they have not traded by 95%. Accordingly, CLS members have to fund with previously. less than US$50 bn a day for every US$1 trillion 7. Increased FX trading of value settled. CLS members also enjoy the benefits of STP, lowered payment volumes and Since FX trading is more secure, efficient and fewer failed settlements. cost-effective in CLS, banks might embrace FX trading for cross-border funds movement on a 3. Offer third-party services more frequent basis. Financial institutions that choose to become 8. Utilization of best practice settlement members of CLS have the

December 2014 opportunity, in turn, to offer CLS settlement Through the use of CLS, participants are services to other institutions on a third-party involved with the industry's best practices for FX basis. settlement, supporting compliance with their internal audit requirements. 4 Streamline risk management 9. Optimize central bank relationships As well as the clear advantages of the elimination of settlement risk, CLS provides operational Central banks around the world are staunch CCIL Monthly Newsletter oversight and controls throughout the advocates for participation in CLS. Financial

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institutions that become settlement members currencies, legislation can take years rather help support common global goals that than months to be passed. Perhaps, if they contribute to financial stability. are not added soon, those currencies will continue to grow outside CLS. CLS: Issues and Challenges: Exchange greats 1. The FX market has grown tremendously Global foreign-exchange market* over the past 11 years. When CLS started, it %of average daily turnover processed an average of 5,700 payment 0 10203040 instructions each day. At the height of the 87.0 US Dollar 84.9 2008 crisis, it processed 1.5m instructions on a single day and settled over 10 trillion U.S. dollars. The utility should be capable enough to process increased trade volumes British pound effectively and efficiently over the years to come.

Canadian 2. The greater problem facing CLS is to dollar accelerate the addition of new currencies it

settles. The most recent were the Mexican Chinese yuan

peso and the Israeli shekel, back in 2008. Nwe Zealand Apr 2010 Non-CLS currencies represent only 6.3% of dollar Apr 2013 *Adjusted for local and cross-border inter-dealer daily volume in the triennial BIS survey but double-counting; percentages sum to 200% as two currencies are involved in each transaction they include some of fast-rising importance, Source: BIS Not covered by CLS such as the Chinese Yuan and the Russian 3. Another issue is the CLS transaction Rouble. The Yuan vaulted into the top ten processing cost. Transaction fees are based most-traded currencies in the latest survey on a value volume cost model and fees that (see chart), although further growth in members pay can vary from one bank to the international trading of the currency could next. With an increase in trading volumes rely, to some extent, on its joining CLS. The more trades are settled through the CLS December 2014 Brazilian Real, Chilean Peso, Thai Baht and system; to keep up with the pace CLS has Polish Zloty are also high on the list of had to invest in technology and risk priorities. management to service these trades. The cost Addition of a new currency is not an easy of increased regulatory compliance proposition, it requires the full support of requirements has also been cited as one of officials in the prospective country the reasons why the baseline fees as paid by

CCIL Monthly Newsletter including regulators and the central bank. banks have hiked over the years. However committed CLS is to adding more

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In fact in 2013, CLS Group (CLS), A derivatives contract is “cleared" when the announced the successful completion of an performance of the buyer and the seller is equity capital raise for a net amount of £160 effectively guaranteed by a special purpose million, which enabled it to comply with financial utility known as a central clearing. increased regulatory capital requirements, Foreign exchange swaps and forwards are meet operational needs and establish an exempt from central clearing framework appropriate capital structure to benefit from under the Dodd Frank Act for the reason future growth in the global FX market. that the main attendant risk- settlement risk 4. Concerns also have been raised on the third is addressed through the CLS mechanism. party model- that some third parties were so However the CLS Bank does not guarantee large that the banks (Settlement members) the settlement of such instruments. The may not have the capability and risk component of market risk still exists for all mechanism to handle such exposures. While such instruments that are settled through CLS believes that systematic risk is reduced CLS, which in the case of forwards can be if large institutions settle FX transactions as high. direct members, however not all third In India, this risk is recognized and clearing parties can get to be direct members under of forex forward has been mandated by the the CLS Bank rule criteria. Central bank. CCIL, based on robust risk The flip side is that while third - party management systems has been able to services have increased manifold post the effectively clear forex trades for the Indian Lehman crisis, a majority of these are made market through its guaranteed USD INR & up of corporate, hedge funds, pension funds Forex Forward settlement products. etc (who find it convenient to settle net Mandatory central clearing of FX products through CLS), all such third - parties carry raises questions about how CLS will the element of settlement exposures on their mitigate settlement risk for cleared products agents. No rules have been made to bring such as options, and whether clearing such entities direct under the CLS ambit. houses can become direct members of CLS.

5. One of the consequences of the Global Having very effectively concentrated its December 2014 Financial Crisis has been a sharply increased efforts on the reduction of settlement risk in focus on regulating OTC derivative years gone by, CLS has never had to concern markets; one of the key areas of increased itself very much with counterparty credit regulatory focus being counterparty credit risk, which is mitigated in other asset classes risk mitigation by moving towards by central counterparties (CCPs). But as centralized counterparty clearing for OTC dealers and CCPs now grapple with the derivatives. challenge of clearing over-the-counter - FX CCIL Monthly Newsletter options - having so far cleared only non-

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deliverable forwards - CLS will need to expansion of settling same-day trades in determine how settlement risk will continue other parts of the world. to be mitigated when a CCP is added to the 4. In continuation with its strategy to support market ecosystem. expanding markets, CLS has a clear goal of CLS's Strategy-Providing Risk Mitigation expanding its currency coverage and is services to the Fx markets: effectively working towards expanding the currencies it settles. 1. The nature and dynamics of the FX market have been in a state of constant flux over the CLS: The India Story: last decade and, consequently, CLS has seen On the lines of the guaranteed settlement model significant change in terms of what the of USD/INR inter-bank-trades (operating at market requires of it. In 2007, CLS began netting efficiency of over 95%) the Indian providing settlement of payments for the financial markets sought benefits of reduced DTCC Deriv/SERV's Trade Information credit, market, operational and liquidity risk and Warehouse, a central post-trade processing improved operational efficiency for trades in service for over-the-counter credit derivative other currency pairs as well. transactions. CCIL selected the Continuous Linked 2. In 2009, with the rise of algorithmic trading, Settlement (CLS) system for cross-currency CLS began its trade aggregation service - transactions. However, rather than directing named CLS Aggregation - to address the individual banks' trade to CLS Bank, CCIL demand driven capacity issues that were sought to simplify access for Indian banks. CCIL responsible for bottlenecks in some acts as third party aggregator and settles the financial institutions' back offices. transactions of its member banks through a Aggregation helps to compress the number designated settlement member Royal Bank of of tickets that are settled and reduce Scotland (RBS). operational risk and is a service that entities CCIL facilitates the settlement of cross currency like hedge funds cherish. deals for banks in India in 14 CLS eligible 3. In 2013, the CLS Group launched new same currencies through the CLS Bank since April December 2014 day settlement service for US dollar and 2005. CCIL's prime objective was to improve Canadian dollar transactions. The Same- transaction settlement efficiency, mitigate risks, Day Settlement solution was a result of insulate the Indian financial system from client demand to remove FX settlement risk operations-related shocks, and undertake other in the liquid currency pair. The solution activities that help to broaden and deepen the allows members to settle and take delivery of money, debt and FX markets in India. Through this arrangement, CCIL has been able to pass on CCIL Monthly Newsletter transaction on the same day. This first same- day session will provide a model for future concrete benefits of the CLS product viz.

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operational efficiencies, reduced liquidity currency wise net positions and obligations, requirement and other benefits to its member and of payments made and received. banks. 3. The service also offers its members the India is the only country in the world where facility to pay and receive currency settlement of cross currency transactions of obligations within the operating timelines major market participants is done through a of the respective currencies, subject to unique fourth party model. availability of limits.

Additional benefits for banks in India: 4. Enhanced credit lines: CCIL accepts collateral in local currency, and by virtue of Banks in India (currently 34) availing the services its role as a Central Counter Party, is able to of CCIL do so as fourth parties. CCIL acts as an offer banks the ability to leverage on their aggregator in the process and is termed as a third unutilized collateral posted towards party and hence is in a position to operationally margins for its settlement services. By using simplify the process for banks and offer CLS local collateral banks can get the benefit of services. early payouts so that they can deploy the The banks that have joined CCIL as members funds in the local markets. Under the have of course availed the risk mitigation umbrella of CCIL, the CLS solution has benefits that CLS offers. In addition they gained immense credibility with the benefited by:- domestic participants.

1. Ease of operations - CCIL has also been able CCIL CLS Fact File: to leverage its infrastructure and capabilities • Live Operations commenced value April 06, as a CCP including making use of the 2005. connectivity and communication already • Settlement Agent - Royal Bank of Scotland, established with the banks and leverage London. unutilized balances of their margin pool • Aggregator of trades reported by Member placed with the CCP for meeting the margin banks in India & Settlement on Payment requirements of segments to collateralized versus Payment. payouts in some currencies etc.

• Currently offers settlement in 14 CLS December 2014 2. Lower costs both because of fewer system eligible currencies. changes are required at the member's end to • As on date 34 members as fourth parties in access the solution as it is web based and the CCIL CLS segment out of which 32 are because CCIL's aggregation model brings live in production. them volume discounts. • Average number of trades settled per day - A real-time web based tool enables members 2000+.

CCIL Monthly Newsletter to track online status of deals submitted, of • Average gross volume of USD 3 billion per day.

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CLS: Large-scale Benefits benefits from using CLS include higher visibility of the settlement process (via real-time CLS is today recognized as a powerful tool for reporting), matching of trades, netting of reducing operational effort and risks on FX payments and process automation. Based on the trades - as well as costs - while also lowering current credit climate situation, the growth of settlement risk. Besides reducing risks, the CLS users will continue in the coming years.

CLS Settlement Process Flow Chart

Party A Party A (4th party) Trade Party B Nostro

Net payment message CCIL (3rd party) Party B's Settlement Agent CCIL's (SA) Nostro CCIL Settlement Agent RBS

Trade Instruction Match Net Net payment payment message message CLS Bank

Party B's SA RBS Nostro Nostro

payments

CCIL CLS Top 3 currency pairs (Figures in USD bn)

450

400 387 386 EUR/USD

USD/GBP 350 U JPY/USD S 300

December 2014 D 250 B 250 i l 200 l 200 i o 140 n 150 133 130 s 111 100 100

48 50 38 34

CCIL Monthly Newsletter

0 2010-11 2011-12 2012-13 2013-14

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CCIL CLS Volumes (Figures in USD bn)

800 700,000

700 594,816 570,308 600,000 T 600 R 724 630 500,000 A G 441,933 D R O 500 394,415 E S S S 647 400,000

V 400 470 S O 300,000 E L L U 300 E M E C 200,000 T 200 E D 100,000 100 77 61 55 55

0 0 2010-11 2011-12 2012-13 2013-14

Gross Volume Net Volume Trades Settled

References:

CLS Bank website BIS Website Fx week Risk.net The Economist

December 2014

CCIL Monthly Newsletter

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ANNEXURE BIS Triennial Central Bank Survey Results 2013

Foreign exchange turnover in April 2013: jurisdictions and reported national aggregates to global results the BIS, which then calculated global aggregates.

The BIS Triennial Central Bank Survey is the Highlights of the 2013 survey: most comprehensive source of information on the size and structure of global foreign exchange Global Market Turnover (FX) and OTC derivatives markets. Foreign Trading in foreign exchange markets averaged exchange market activity has been surveyed every US$ 5.3 trillion per day in April 2013. This is up three years since 1989, and OTC interest rate from US$ 4 trillion in April 2010. Spot market derivatives market activity since 1995. The trading increased by 38% to $ 2 trillion per day in Triennial Survey is coordinated by the BIS under April 2013.This contributed roughly a 40% rise the auspices of the Markets Committee (for the in global Fx market activity between 2010 & foreign exchange part) and the Committee on the 2013. Fx swaps continued to be the most actively Global Financial System (for the interest rate traded instrument in 2013 although at 27% the derivatives part). The latest survey of turnover rise in trading did not match the velocity with took place in April 2013. Central banks and the overall market. Fx swaps daily volume of $2.2 other authorities in 53 jurisdictions participated trillion accounted for 42% of all Fx related in the 2013 survey. They collected data from transactions. about 1,300 banks and other dealers in their

GLOBAL TURNOVER (Daily averages in April in US$ billion)

Instrument 2013 2010 % difference

Foreign exchange instruments 5,345 3,971 35 Spot transactions 2,046 1,488 38 Outright forwards 680 475 43

December 2014 FX swaps 2,228 1,759 27 Currency swaps 54 43 26 Options and other products 337 207 63 Turnover at April 2013 FX rates* 5,345 3,969 35

* Non-US dollar legs of foreign currency transactions were converted into original currency amounts at average exchange rates

CCIL Monthly Newsletter for April of each survey year and then reconverted

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Foreign exchange market turnover by instrument1 Net-net basis, daily averages in April

2001 - 2013 2010 2013 USD bn 1% 1% 5,000 5% 6%

4,000

3,000 37% 38%

2,000 44% 42%

1,000 12% 13% 0 01 04 07 10 13 Spot Outright forwards FX swaps Currency Swaps Options & Other

1Adjusted for local and cross-border inter-dealer double-counting, ie "net-net" basis.

Turnover by Currencies 2010. The turnover of the Japanese yen increased The US dollar remained the dominant vehicle significantly between the 2010 and 2013 surveys. currency; it was on one side of 87 percent of all So too did that of several emerging market trades in April 2013. The euro was the second currencies, and the Mexican peso and Chinese most traded currency, but its share fell to 33 yuan entered the list of the top 10 most traded percent in April 2013 from 39 percent in April currencies.

CURRENCY DISTRIBUTION OF FX TURNOVER -- TOP 10 CURRENCIES (Percentage share of average daily turnover in April)*

No. Currency 2013 2010 2010 Rank

1 US Dollar 87 84.9 1 2 Euro 33.4 39.1 2 3 Japanese yen 23 19 3

4 11.8 12.9 4 December 2014 5 Australian dollar 8.6 7.6 5 6 Swiss franc 5.2 6.3 6 7 Canadian dollar 4.6 5.3 7 8 Mexican peso** 2.5 1.3 14 9 Chinese yuan** 2.2 0.9 17 10 dollar** 2.0 1.6 10

CCIL Monthly Newsletter *Because two currencies are involved in each transaction, the sum of percentage share of individual currencies totals 200 percent. ** Turnover for years prior to 2013 may be underestimated owing to incomplete reporting of offshore trading in previous surveys.

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Turnover by Currency Pair expanded less than that in their USD counterparts The USD/EUR currency pair retained its dominant position amongst the most actively Among the most actively traded advanced trades currency pair. Among the major economy currencies, the Australian and New currencies, trading in the Japanese yen jumped Zealand dollars continued increasing their share the most, Turnover in the USD/JPY pair rose by in global FX trading. By contrast, sterling, the about 70 percent in this period.. Trading in the Canadian dollar, the Swedish krona and, most most actively traded euro exchange rate crosses, notably, the Swiss franc lost ground in global FX such as EUR/JPY, EUR/GBP and EUR/CHF, trading in relative terms

TURNOVER BY CURRENCY PAIR (Daily averages in April in US$ billion and percentages, excluding estimated gaps in reporting)

2013 2010 Currency pair Amount % share Amount % share USD/EUR 1289 24.10 1098 27.7 USD/JPY 978 18.30 567 14.3 USD/GBP 472 8.8 360 9.1 USD/AUD 364 6.8 248 6.3 USD/CAD 200 3.7 182 4.6 USD/CHF 184 3.4 166 4.2 USD/MXN 128 2.4 Na Na USD/CNY 113 2.1 31 0.8 USD/NZD 82 1.5 Na Na USD/RUB 79 1.5 Na Na USD/HKD 69 1.3 85 2.1 USD/SGD 65 1.2 Na Na USD/TRY 63 1.2 Na Na USD/KRW 60 1.1 58 1.5 USD/SEK 55 1.0 45 1.1

December 2014 USD/ZAR 51 1 24 0.6 USD/INR 50 0.9 36 0.9 EUR/JPY 147 2.8 111 2.8 EUR/GBP 102 1.9 109 2.7 EUR/CHF 71 1.3 71 1.8 JPY/AUD 45 0.8 24 0.6

CCIL Monthly Newsletter

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Turnover by Counterparty 2010 and 2013 surveys, reducing their share of global turnover to only 9 percent. The growth of foreign exchange trading was driven by financial institutions other than Geographical distribution of turnover reporting dealers. The 2013 survey collected a Foreign exchange market activity has become finer sectorial breakdown of these other ever more concentrated in a handful of global institutions for the first time. Smaller banks (not financial centers. The vast majority of global FX participating in the survey as reporting dealers) trading in 2013 has occurred via the accounted for 24 percent of turnover, intermediation of dealers' sales desks in five institutional investors such as pension funds and jurisdictions: the (41 percent), insurance companies 11 percent, and hedge the (19 percent), (5.7 funds and proprietary trading firms another 11 percent), (5.6 percent) and percent. Trading with non-financial customers, SAR (4.1 percent). mainly corporations, contracted between the

FOREIGN EXCHANGE TURNOVER BY COUNTERPARTY (Daily averages in April in US$ billion and percentages) 2013 2010 Counterparty Amount % share Amount % share Reporting dealers 2070 38.7 1544 38.9 Other fin. institutions 2809 52.6 1896 47.7 Non—fin. customers 465 8.7 532 13.4

TURNOVER BY LOCATION - TOP 5 COUNTRIES* (Daily averages in April in US$ billion and as percentages)

2013 2010 Country Amount % share Amount % share 1. United Kingdom 2,726 40.9 1854 36.8 2. United States 1263 18.9 904 17.9

3. Singapore 383 5.7 266 5.3 December 2014 4. Japan 374 5.6 312 6.2 5. Hong Kong 275 4.1 238 4.7

CCIL Monthly Newsletter

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Pct Daily BIS Trienniel FX Survey-Pct Daily Vol vol/Dealing Location 2013

45.0 40.0 35.0 30.0 25.0 20.0 15.0 10.0 5.0 0.0

Japan Singapore United States United Kingdom Hong Kong SAR

December 2014

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