Is CLS Part of Your FX Risk Handling Strategy?

The purpose behind the CLS Group, which was founded in 1997 by the foreign exchange (FX) community, and continuous linked settlement (CLS), was to create the first global settlement system, eliminating settlement risk in the FX market.

Since its introduction in 2002, the CLS system has developed into the leading market standard for FX settlement. Today, based on the CLS market share report (CLS Bank, February 2011) nearly 70% of all FX transactions conducted worldwide involve currencies supported by CLS. The service, which is available for banks, funds and corporates settling large FX trades, is the industry’s response to increased and continuing regulatory concern about settlement and system risk associated with the growth in FX trading.

The uniqueness of the CLS concept has led to a considerable growth over the past 10 years. In addition to the 62 CLS bank members, more than 12,000 other participants, including almost 600 banks, are using the services today as third party customers.

Over the years, CLS has developed from supporting only FX trading to handling non-deliverable forwards (NDFs) and over-the-counter (OTC) credit derivatives. The number of currencies eligible for the CLS system now stands at 17.

Corporate Access

CLS bank settlement members are a closed group of banks and financial institutions. How does a corporate gain access to this service?

Settlement members are entitled to share their CLS account with their customers, who become third parties to the service. In other words, a corporate may outsource their FX settlement to their own bank if it is a member of the CLS community. The corporation needs only to set up dedicated settlement accounts at the bank for each of its trading currencies, with suitable short position limits, to allow the daily settlements by the bank towards CLS. These settlement accounts are zero-balanced at the end of each day to a single ordinary account appointed by the customer.

Corporates operating in the FX market today face many challenges, such as the pressure to reduce risk, improve operational efficiencies and comply with an increasing number of regulatory requirements. Corporate treasurers, therefore, need to ensure that they have the right solutions available to meet these demands. Using CLS Bank to settle FX transactions will help corporates address these issues – at the same time reducing the number of bank settlements and manual reconciliations.

Risk Elimination

By using CLS, all risk associated with FX settlement will be eliminated. But what is a settlement risk and how does the CLS system eliminate it? CLS settles transactions on a payment versus payment (PVP) basis and with finality across time zones. When a FX trade is settled, where each of the two parties to the trade pays out (sells) one currency and receives (buys) a different currency, PVP ensures that these payments and receipts happen simultaneously. Without PVP there remains a risk, however small, that one or more parties could pay away funds to another institution but not receive any reciprocal funds due.

In the current market, where the landscape of counterparty risk has changed dramatically, it has become essential – not only for financial institutions, but also for large corporates – to have a well-defined strategy for handling FX trading risk.

Counterparty risk is the risk each party of a contract has to face that the other will not live up to its contractual obligations. Counterparty risk should always be considered when evaluating a contract. In most financial contracts, counterparty risk is also known as ‘default risk’.

Operational risk is another part of this picture, since the operational risk within FX settlement is considered to be high, based on the fact that the trades are settled at gross level (per trade) or, in some cases, netted at counterparty level. Accordingly, there is an extensive need for back-office resources for executing settlements, follow-up on counterparty deliveries, correcting settlement failures, etc. This is a very costly process – both in relation to staff hours, transaction costs and a high level of interest and compensation claims from counterparties.

Straight-through Processing

As indicated above, using CLS also allows the corporate to streamline and automate its entire FX process from deal execution to settlement.

When trade information is delivered to the CLS member (the corporate’s bank) immediately after deal execution, the information is automatically matched with that delivered to CLS by the counterparty. There are various technical ways to provide feedback about non-matching deals – this feedback can be directly channeled to the customer’s deal management platform, or made available through a web tool where the corporation has direct access to all their trades in the CLS process. Automatic matching relieves the corporate of manual collation of trade confirmations.

Once the trade information has been successfully matched, CLS can happen without further actions from the corporate. More and more customer cases show that CLS makes it possible to achieve substantial reduction in operational processing, increased reconciliation speed, dramatically reduced error rates and increased availability of credit lines.

Preparing for an Integrated CLS Solution

As simple and attractive as the CLS concept looks, it is important to note, before going into implementation mode, that there are quite a few details to consider. Corporates interested in the CLS system are recommended to produce a business case based upon a proper analysis of existing back-office processes, the future risk strategy, cost savings initiatives, etc. In order to be able to settle FX trades via CLS the company has to sign up for the service via a bank offering CLS third party settlement services. They also need to ensure that their key counterparties have access to CLS.

They also have to look inwards to their existing technical infrastructure. To set-up a straight-through processing (STP) integrated CLS solution towards the CLS bank, the company needs to study the capabilities of their treasury management system (TMS) and/or enterprise resource planning (ERP) system. A full STP set-up may require some further development by the system vendor.

CLS: Large-scale Benefits

CLS is today recognised as a powerful tool for treasury when establishing strategies for reducing operational effort and risks on FX trades – as well as costs – while also lowering settlement risk. Besides reducing risks, the benefits from using CLS include higher visibility of the settlement process (via real-time reporting), matching of trades, netting of payments and process automation. A high proportion of the entities settling through CLS are already corporates or non-bank financial institutions. Based on the current credit climate situation, the growth of this group of CLS users will continue in the coming years.

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