CLS - Gathering Speed

CLS (Continuous Linked Settlement) is an initiative by the 57 shareholder banks making up the organisation to eliminate the settlement risk involved in Foreign Exchange trades.

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By  Peter Conmy Published  March 28, 2001

CLS (Continuous Linked Settlement) is an initiative by the 57 shareholder banks making up the organisation to eliminate the settlement risk involved in Foreign Exchange trades. This involves the settlement of deals through a single, central organisation, on a payment versus payment basis and within strict time limits.

With CLS due to go live in the autumn of 2001, interest in the scheme is growing and preparations are gathering momentum. We report on the views of two very different banks, both of which are wholeheartedly committed to participation in CLS, albeit in contrasting roles.

HSBC, one of the world’s major banking groups and a CLS shareholder and prospective settlement member, is a leading proponent of the new service, as is BHF Bank, which has opted to become a third-party user of the new CLS service.

Bob Jones, HSBC’s Senior Business Development Manager for Global Payments & Cash Management, explains, "I believe the introduction of Continuous Linked Settlement will result in a massive shake-up in the banking industry. However, it is important to point out that CLS is not being introduced for the benefit of shareholders alone, but for the industry as a whole. For this reason, it is imperative that third-party or non-member banks become involved as quickly as possible.

Achim Vogt, Head of Organisation & Control for the London branch of Berliner Handels und Frankfurt Bank (BHF Bank), concurs with this view, and says "CLS is a breakthrough for the industry. Payment versus payment has been adopted as an industry standard by the securities market and been proven to operate successfully for decades. Now, for the first time, CLS will provide standard terms for foreign exchange settlement as well as offering a number of incentives to users, the elimination of settlement risk being the most obvious."

BHF Bank has already contracted to use the new CLS service as a third-party bank, and will settle its foreign exchange trades via a member bank.

Achim Vogt comments, "For those banks which choose not to become involved in CLS in one capacity or another, I foresee the emergence of a two-tier price structure within the market. Banks not involved in CLS may have to trade at uncompetitive rates, since settlement risk may be priced into quotes. This will reduce trading margins and in turn, will adversely affect profits. For this reason, BHF made the decision early on to join CLS, to avoid foreign exchange margins being squeezed and possibly additional capital charges being imposed by BIS."

"I believe CLS will become accepted as the industry standard within a couple of years, just as the SWIFT service did," Achim Vogt continues. "The objective of all banks is to remain competitive; therefore, if CLS leads to the emergence of a two-tier price structure with settlement risk being factored into quotes, CLS participants will be able to take advantage of beneficial prices."

He ends by saying, "Smaller dealer rooms are already experiencing a reduction in margins and losing business to larger trading floors which can offer better prices through economies of scale. This situation could be exacerbated still further by non-participation in CLS."

Bob Jones of HSBC makes the point that, "From the bank’s perspective, there are two main issues; we need to show that HSBC is fully supportive of the service and ready for its launch, as well as being in a position to make the service available to third-party banks. In fact, we have had a third-party proposition in place for some time, and have already received verbal commitments from a number of banks. One of the major advantages we have is that HSBC is, we believe, the only banking group with direct access to all 7 RTGS (Real Time Gross Settlement) Systems in each of the countries whose currencies will be settled through CLS."

Bob Jones adds, "One of the motivating factors behind HSBC’s involvement in CLS was its use in settling the bank’s proprietary trades, which otherwise might incur a capital charge in respect of foreign exchange settlement risk by the Bank for International Settlements (BIS). Obviously, this will be one of the major benefits for banks choosing to settle their proprietary FX trades via CLS."

"Because of the investment required in the underlying technology, combined with a squeeze on margins and the need for a large volume of foreign exchange trades to maintain profitability, the introduction of CLS will cause a massive shake-up in the industry. I believe this will undoubtedly result in the rationalisation of banking relationships, with the eventual result being the emergence of a few super-regional and global banks acting as the sole user member in each region."

He goes on to say, "Without a doubt, the service will identify the serious players in the business, such as HSBC, since the bank is wholeheartedly committed to the introduction of CLS and has made a serious investment in the underlying technology. HSBC will be adopting the service to settle its proprietary trades in the belief that it will provide benefits not just for the bank, but for the industry as a whole."

"This is demonstrated by HSBC’s readiness to provide third-party services, our ability to provide innovative and competitive pricing, and to start testing with system vendors such as MKI. We now need more third-party banks to become involved, although many may be unaware of the underlying implications CLS has for their business."

Bob Jones concludes by saying, "Choosing a settlement bank will be one of the key decisions and issues that all third-party banks will need to address in the immediate future; the following criteria, by no means exhaustive but important in the selection process, should be considered:
» Will the settlement bank be ready for CLS on live date and have a third-party solution accessible at that time?
» Can they provide pricing to the third party?
» When can third parties begin testing with their chosen settlement bank?
» What are the capabilities for the reporting of Management Information in real time, and how will this information be accessed?
» What are the long-term strategic plans of the settlement bank? Will they be providing payment and clearing services alongside cash management tools?
» Ability to provide multi-currency solutions across a global platform in the future

John Burton, MKI’s Strategic Marketing Manager, comments, "As yet, there is little evidence to indicate that most third-party banks have formulated a strategy with regard to adopting CLS. This could be due to uncertainty over the start date and initial delays involved in development of the central settlement system. Other issues such as pricing are expected to be resolved early in 2001, although confidence is another issue, since there has been some difficulty in gaining commitment to a concept until the service is actually up and running."

"We believe that CLS will become the established means of settling foreign exchange trades in the eligible currencies," he adds. "As more third-party banks use the system, peer group pressure is likely to be exerted, as banks will prefer to deal with counterparties where the settlement risk has been eliminated."

He goes on to say, "MKI counts the largest installed base of banking system customers in the world. With over 1,000 banks dependent on MKI banking systems in their back-office, it is natural to expect MKI to take a pro-active stance in developing new functionality, and CLS is no exception. Whether it is for a branch of a settlement member or a bank that has chosen to participate in CLS as a third party, MKI has already developed and tested a CLS module for its clients, in anticipation of customer demand."

"MKI customers expect the company to take the initiative and have vital software enhancements available and ready for implementation at the right time, as was the case with the Euro and Y2K. Several clients have already contracted for CLS enhancements, including a settlement member and a third-party participant.

"We firmly believe that CLS will provide our customers with significant benefits, both in terms of a reduction in risk and better use of capital and would encourage our user base to give serious consideration to participating in CLS, and make the necessary arrangements in good time.

"We obviously wish to provide a speedy implementation service and would prefer to avoid a bottleneck created by large numbers of banks all wishing to upgrade their systems at the eleventh hour," John Burton concludes.

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