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

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ARtICLE Continuous Linked Settlement (CLS): Then and Now (Including a snapshot of the BIS Triennial Central Bank 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 clearing 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 7 ARtICLE 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, Chilean peso, 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 Herstatt Bank. CLS The biggest testament to the success of CLS is had done its job. The European Central Bank, 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.” 8 ARtICLE 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 banks 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 9 ARtICLE 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 Euro on a single day and settled over 10 trillion U.S. dollars. The utility should be capable Japanese yen enough to process increased trade volumes British pound effectively and efficiently over the years to Australian dollar come. Swiss franc Canadian 2. The greater problem facing CLS is to dollar accelerate the addition of new currencies it Mexican peso 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 10 ARtICLE 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.
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