The foreign exchange (FX) market is the most global and liquid of the financial markets and trades approximately US$4 trillion1 each day in different currencies, around the world and around the clock. It is now an asset class in its own right and forms the backbone of the global payments system, helping to underpin global economic activity and international commerce.
This increasingly liquid and transparent asset class has attracted a more diverse investor and trader base beyond the traditional corporate and government users to include hedge funds and diversifying asset managers and pension funds. The dynamics of the market are also changing rapidly. Trading patterns are dividing between those participants who want physical delivery of their purchased currency, and those that simply want to exchange the net economic effect of all trades undertaken with each major counterparty. These factors, combined with the adoption of electronic and algorithmic trading and advances in trading technology, offer more competitive pricing and lower transaction costs and have propelled FX trading growth to new heights.
However, although the market has resumed its growth in volumes and values, the awareness of exposure to credit, settlement and operational risk has also increased. As FX includes the exchange of the principal amount in spot, forwards and swaps, by far the largest single risk factor in FX remains settlement risk. The banking industry has already adopted a disciplined global settlement standard and its performance throughout the financial crisis clearly demonstrated the effectiveness of this collective solution.
The Financial Crisis
During the collapse of Lehman Brothers in the week of 15 September 2008, the FX market withstood the shock and repercussions. A major contributor to the continued operation of the FX market during this period was CLS, the global, multi-currency cash settlement system established by the industry to mitigate settlement risk. During ‘Lehman’s Week’, CLS delivered the orderly settlement of every single one of its outstanding payments during that time, underlining to its participants and the wider market the very raison d’être of the service and its risk model.
It was these events that reminded the industry that settlement risk in FX dwarfs the other risks in the industry. A recent study undertaken by Oliver Wyman2 concluded that settlement risk comprises 94% of the maximum loss exposure in a trade for FX instruments with maturity of less than one year, and 89% for instruments with maturity of greater than one year. Such is the importance placed on the need to eliminate settlement risk, several CLS members no longer trade with those who do not use CLS for interbank settlement.
As settlement risk became front of mind for participants and regulators alike, the number and type of participants using CLS grew rapidly in the aftermath of the financial crisis and the trend still continues today. As at 31 December 2010, there were 10,886 registered participants of CLS, a 202% increase from September 2008.
Enhanced Risk Mitigation
There has never been a greater consensus between banks and regulators to improve risk mitigation and grow CLS participation. However, one area of CLS participation that still needs to be developed is that of corporates.
Though the volume and values transacted by financial entities is growing most rapidly, there is growth in corporate trading values as globalisation and economic growth continue. Corporates operating in the FX market to hedge against business risks often perceive settlement risk as ‘a bank issue’. However, those corporates already using CLS continue to report that with the elimination of settlement risk and shorter, more secure settlement periods, corporates can significantly improve their operational control and oversight of their FX settlements, as well as consider new FX counterparties. For corporations that use a panel of banks for trading and hedging, there will be settlement risk unless they maintain the appropriate currency accounts at all their FX banks so as to settle trades across the books of a single bank. Perhaps ironically the fund managers of hundreds of corporate pension funds now insist on CLS settlement for trades done with their panel of broker banks.
Corporates enter the FX market to fund obligations arising from business transactions and to facilitate hedging of existing financial positions. Key to this is a high degree of accuracy in the management of cash flows. Many corporates already have integrated financial systems that are able to aggregate financial obligations to provide accurate cash forecasts that in turn feed the required FX values needed to support the business. Before CLS, this global view of cash positions was not totally transparent when it came to FX. CLS enables participants to access a global view of their FX trades, their status from which to build positions in ‘near time’, providing a certain forecast for their FX funding requirements. Where previously funding arrangements had to be organised up to 24 hours in advance or collateral posted, CLS enables same day funding, with the consequential cost savings on interest and associated liquidity overheads.
This same day funding of the CLS cash settlement cycle minimises the time funds are tied up to prepare for and complete settlement. Furthermore, settlement in CLS occurs on a gross, individual payment versus payment basis, but funding required for settlement is calculated on a multilateral netted basis. This reduces the cash values required to settle by over 98% for members and certainly reduces the number of payments that must be made to CLS. This netting effect also reduces the size of intra-day credit lines required. Totally accurate cash forecasting, minimising the number of payments needed to settle a day’s trades and reducing trading errors and manual processing, means that participants are able to improve their cash management and trade reconciliation cycle.
CLS delivers cost savings through operational efficiencies. Some of the benefits include enhanced straight-through processing (STP), a reduced number of cash settlements and associated transaction costs, reduced errors with no instances of settlement failure, and more efficient allocation of monetary and physical resources. Currently, rejected trades are less than one-hundredth of 1% of daily volumes.
Corporate participants select a service provider from more than a dozen third parties who are CLS members. Once live, CLS participant banks and the corporate send a confirmation of each trade, which are matched in CLS. This match is normally made well within one hour of the trade being executed. Any issues arising can be actively managed on trade date rather than the cumbersome process of resolving issues following a settlement failure. Timely matching eliminates failed settlements and consequently, any resulting interest and compensation claims.
A New Era: Regulation and Reforms
Although the FX market has an effective solution in place to mitigate the largest risk in FX, it has not escaped the scrutiny of regulators and legislators. The reforms underway are intended to usher in a new era of greater transparency, information sharing, reporting and oversight of the over-the-counter (OTC) markets.
For FX, there are two areas where legislation or regulation are new:
- A standardised approach to the reporting, storage and dissemination of financial market information.
- The introduction of a mandated central counterparty (CCP) for all FX derivatives that, at time of writing, were all FX instruments, except for spot. Corporates need to be aware of the implications on FX transactions and the unintended consequences the proposed legislation could impose on their businesses.
At the time of going to press, financial industry participants are finalising proposals to respond to the regulatory demand for a central trade repository. At the same time, in the US, the specific details as to which FX products will be subject to mandated clearing remains to be confirmed. The choice made in the US would seem almost certain to be repeated in the EU. Under the current Dodd-Frank and European reforms, while non-financial institutions seem likely to gain a level of exemption from central clearing, clearing will introduce margin management disciplines for those who have to use clearing including any corporations that fall within the mandated levels, and like the majority of financial participants, have not previously had to process or manage for FX.
Perhaps more significant could be the impact the reporting requirements will have on corporates. The guidelines for repositories were published by the Commodity Futures Trading Commission (CFTC) at the end of 2010 for US registered and regulated repositories. The reporting obligations are comprehensive and all encompassing. Some of the reporting requirements require both a timeliness and precision with regards to counterparty definition that set a new standard. Another area requiring further clarity is whether or not corporates can use their financial counterparties to fulfil their reporting obligations. If not, the implications for corporates will be significant in terms of the re-engineering of post trade processes.
Whatever the outcome of these reforms, a fundamental shift in the FX post-trade environment is likely. The growth in participation and volumes shows no signs of abating, with the most recent Bank for International Settlement (BIS) Triennial Survey reflecting this market trend. As the industry arguably faces its biggest shake up, the primary objective for CLS is to ensure that any outcome will not reintroduce any element of settlement risk into the market. We remain committed to extending our coverage to further reduce settlement risk, through its ongoing participation, currency and additional settlement session programmes and ultimately expanding the share of the FX market being settled (currently 68%3).
The industry has come along way in addressing the risks in FX. CLS participation has brought real benefits to its participants, including corporations, in terms of risk reduction, time value of cash assets, and improvements in operating efficiency and automation. The next steps being mapped out are all designed to reduce credit risk and improve oversight literally by tracking and reporting trading. Against this background there will likely be far less tolerance for manual or tardy operational processes. The regulatory agenda for financial markets and FX has never been so operationally focused.
1 BIS Triennial Central Bank Survey of Foreign Exchange and Derivatives Market Activity in April 2010 – Final Results (December 2010).
2 Oliver Wyman/AFME 2010.
3 Based on information in the CLS settlement service and recent central bank and market surveys.
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