New forex settlement system helps reduce risk

  • Business
  • Friday, 04 Apr 2003


IT HAS been described as “a revolution” which will reduce risk and lower costs for a global foreign exchange (forex) trading system that has remained largely unchanged for the past three centuries.  

Continuous Linked Settlement (CLS), a new forex transaction and settlement system, established by the Group of Twenty (G20) world’s largest financial institutions, is set to eliminate settlement risk and promises bankers a much better night’s sleep.  

CLS Bank International, which offers the service through 51 settlement members, said it was presenting the forex market with its first ever “simultaneous and irrevocable global multi-currency settlement system.”  

In other words, CLS eliminates the risk of default in settlement – a major concern in forex transactions – by making same-day simultaneous settlements on a payment-versus-payment basis both possible and final. 

Currently, the risk of one party to a forex trade defaulting is high as each side of the trade is paid separately. Settlement risk comprises what bankers call credit and liquidity risks. Credit risk arises when a counter-party cannot meet an obligation for the full value on the due date because it is insolvent. Liquidity risk, meanwhile, refers to the risk that a counter-party will not settle for full value at due date but could do so later; causing the party which did not receive its expected payment to finance the shortfall at short notice.  

As forex deals are not immediately matched due to time-zone differences between the contracting parties, as well as in the use of different payment systems and correspondent banks, situations can often arise when one party delivers the currency being sold but does not receive the currency bought from his counter-party.  

Wolfgang Platzer

Experts said that as settlement risk involved the principal or full amount of the transaction the daily global forex market turnover of almost US$2tril was put at risk every day.  

Individual banks’ total exposures could dangerously exceed their capital. Any mechanism that removes this uncertainty would, therefore, significantly lower overall risk.  

At a recent seminar in Kuala Lumpur attended by representatives from all major Ma- laysian banks, ABN Amro Bank, one of the founder members of the CLS, said risk reduction was a key reason why CLS had become increasingly popular.  

After six months of operations, CLS deals already account for 10% of daily forex volumes worldwide and its share of transactions, currently averaging 60,000 trades totalling US$600bil in value per day, was increasing fast. 

On one single day in February, CLS Bank settled trades with a gross value of over US$1tril for the first time. The bank said it was “a prelude to the level of daily volume and value later this year.” In the period since its inception, transactions settled through the CLS have exceeded one million trades totalling over US$40tril in value. 

ABN Amro Asia Pacific regional sales head Wolfgang Platzer said that although the system was gaining popularity, the take-up rate in Asia had been small. In a recent survey, 70% of Asian financial institutions said they had decided on a CLS strategy with the system expected to account for 58% of their future forex settlements. 

Roland Merkelbag

However, the migration to the CLS has been slow. Only 6% of Asian banks used the CLS while no Malaysian banks have so far chosen a CLS service provider. 

A participant at the seminar said that the slow acceptance of CLS in Asia was due in part to the absence of most major Asian currencies in the CLS. (Currently, the seven currencies included are the US, Canadian and Aussie dollars, euro, sterling pound, Swiss franc and Japanese yen.)  

He, however, agreed that the CLS would be beneficial to his bank, particularly in risk management, and told StarBiz: “It’s not a matter of ‘if’ but ‘when’ we start using the CLS.”  

Platzer said he expected the lukewarm reception in Asia to change soon as new currencies and products were added. The Singapore dollar would be included in the CLS in May while the Hong Kong and Taiwan dollars and Korean won were under consideration for inclusion next year, he said. 

According to Platzer, in Singapore, for instance, the three largest Singaporean banks started a project over a year ago to establish a shared utility service vehicle to become a settlement member at the CLS Bank.  

ABN Amro advised Malaysian bankers not to delay migrating to the CLS. It said the implementation process could be lengthy and as there were only a small number of service providers, bottlenecks could become an issue for latecomers.  

CLS Bank said a number of fundamental changes in operational practices were required for banks to fully reap the benefits of the CLS. This will range from IT infrastructure to the way they conduct business in terms of liquidity and risk management, correspondent banking, trading and operational management.  

“Banks will need to forecast funding obligations carefully and manage their liquidity requirements to ensure they satisfy the requirements. Those banks that can meet the challenge of efficient liquidity management will have more cash available for lending, investing and funding operations,” its chief executive officer Joseph de Feo said. 

Some Malaysian bankers cited the absence of the ringgit from the CLS as a reason for the “wait and see” attitude and said it could be difficult to justify the new investments, especially when only a small percentage of trade volumes settled by banks here were done among CLS currencies. 

ABN Amro’s CLS business manager Roland Merkelbag said it could be a matter of time before the ringgit was included. He understood that Bank Negara was looking closely at the concept and consequences of the possible inclusion of ringgit in the CLS. However, he was not aware if the central bank and CLS were in talks to that end.  

Merkelbag, however, added that very large volumes of transactions were not necessary for banks to benefit from the CLS.  

“With only 20%-30% of forex volumes in CLS currencies, banks could make substantial cost savings,” he said.  

Merkelbag said that in the longer term, the growing numbers of CLS-enabled counterparties would mean that the shift to CLS trades could be inevitable.  

He said it was clear why banks worldwide were moving in that direction.  

“Apart from risks being reduced, transactions using the CLS were operationally more efficient due to the high degree of “straight through processing,” he said.  

The system also provided liquidity savings and allowed higher forex lines. 

“Matched CLS trades should not influence your available credit lines with forex counterparties, therefore significantly more trading can be done,” he told Malaysian bankers.  

Merkelbag said he could foresee regulators imposing solvency requirements on banks which did not settle through the CLS in the future, while increasingly more products were settled in the same way.  

CLS services were also increasingly being offered to non-bank institutions such as fund managers and corporations, he said.  

ABN Amro is one of a small number of CLS service providers, which also includes JP Morgan Chase, Citibank, Deutsche Bank and HSBC Bank. 

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