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Optimizing settlement

risk management:
Cls and beyOnd
A White Paper by Wall Street Systems
OPtimizing Settlement riSk mAnAgement: ClS And beyOnd
introduction 3
ClS: solving the settlement risk conundrum 4
the history of FX settlement risk 5
the Herstatt incident 5
the formation and signifcance of ClS 5
the ClS process and its effect on FX trading 6
the current environment and challenges faced
by ClS member banks 6
Alternatives to ClS 8
bilateral netting 8
Same-day or next-day settlement 9
A system for the future 9
Conclusion 10 3
OPtimizing Settlement riSk mAnAgement: ClS And beyOnd
Foreign exchange (FX) settlement risk
the risk of a bank in a foreign exchange
transaction paying the currency it sold
without receiving the currency it bought
is one of the biggest concerns in todays
international banking community. As the
FX market continues its trend of exponential
growth year on year and average daily
trade volumes today exceed $US3 trillion,
its not surprising that FX settlement risk has
dominated the G10 Governors agenda
for over ten years.
FX settlement failures can arise for a
number of reasons: counterparty default,
operational problems and market liquidity
constraints are just a few examples.
Settlement risk is inherent in any trade
activity, but it is the size of the foreign
exchange market that makes FX settlement
risk such an important issue for many
banks, FX transactions are the greatest
source of settlement risk exposure. In some
cases, large banks have almost three times
more exposure to settlement risk than to
credit risk. The sums of money involved are
huge FX transactions can involve credit
exposures amounting to tens of billions
of dollars each day, and in some cases,
exposures to a single counterparty are
in excess of an institutions capital.
Settlement risk has historically been a
problem in foreign exchange markets
because, due to time zone differences,
several hours might elapse between a
payment being made in one currency
and the offsetting payment being made
in another currency. The introduction of
Real Time Gross Settlement (RTGS) has
eliminated some of these risks by providing
real-time settlement. But challenges remain
as speed and real time transactions
become more and more important
in all areas of fnance, including
FX transactions.
OPtimizing Settlement riSk mAnAgement: ClS And beyOnd
ClS: SOlving tHe Settlement riSk COnundrum
Continuous Linked Settlement (CLS) is a real time, global settlement process that reduces
settlement risk caused by foreign exchange transactions occurring across different time
zones. With CLS, both sides of the FX transaction are settled simultaneously signifcantly
reducing settlement risk in the FX market.
CLS is essentially a Bankers Bank for FX settlement. It began operations in September
2002 with the purpose of settling foreign exchange fows between some of the worlds
largest banks along with their customers and other third-party participants.
With CLS, both sides of the FX transaction are settled simultaneously on a payment versus
payment (PVP) basis. This ensures that all payments and receipts for an FX trade occur
simultaneously, eliminating settlement risk.
On average, CLS netting effciency is in the region of 98%. As a result, it has rapidly
become the market-standard for foreign exchange settlement between major banks, settling
approximately 400,000 instructions a day in 15 currencies. This represents 55% of global
FX trading.
Despite this high success rate, CLS has some disadvantages. Membership fees are high,
and the service is relatively expensive on a cost-per-trade basis. Lowering this cost-per-trade
remains a high priority for many CLS users. And while CLS settles over half of the total FX
obligations worldwide, banks must still fnd alternatives for the remaining 45%.
Furthermore, banks face capacity issues because the volume of tickets being processed
is rising faster than the total notional dollars being traded. Additionally, the high cost of
processing these trade tickets is having a negative effect on margins. As trade volumes
continue their steady increase, it has never been more important for banks to develop a
fexible, adaptable trade-processing infrastructure that will help them to reap the greatest
proft from their FX trading activity. 5
OPtimizing Settlement riSk mAnAgement: ClS And beyOnd
tHe HiStOry OF FX Settlement riSk
The foreign exchange (FX) market as we know it today emerged
in 1971 following the collapse of the Bretton Woods agreement
a system of international monetary management established
following the Second World War. The new system for currency
exchange brought with it the hazard of cross-currency
settlement risk. Any bank purchasing currency immediately
risks the full amount of currency purchased from the time that
the payment instruction is confrmed and can no longer be
cancelled unilaterally, until the time the currency purchased is
received and the transaction is fnal. Although FX settlement risk
was immediately recognized and understood, its effects were
not fully appreciated until 1974.

he HersIcII |ncdenI
On 26 June 1974, the banking license of a German bank,
Bankhaus Herstatt, was withdrawn by local regulators.
Although the bank was relatively small, its collapse had
global implications because of the losses suffered by its FX
counterparties. It was ordered into liquidation during the
banking day, but after the close of the German interbank
payments system at 15:30 local time. Some of Herstatt Banks
counterparties had paid Deutschmarks to the bank, believing
they would receive US dollars later the same day in New York.
But when the banking business was terminated, it was only
10:30 am in New York. The New York correspondent bank
suspended all outgoing US dollar payments from Herstatts
account; leaving its counterparties fully exposed to the value
of the Deutschmarks they had paid the German bank earlier
in the day.
The Herstatt case brought the issue of settlement risk to
the attention of the international fnance community, but
unfortunately it was not the last incident of its kind. More recent
examples of what is sometimes still referred to as Herstatt Risk
include the collapse of Drexel Burnham Lambert in 1990, the
fall of Bank of Credit Commerce International in 1991 and
the collapse of Barings Bank in 1995, all of which had global
implications related to FX settlement risk.
Over the years, FX settlement risk has provoked intensive
study and research, including:

The 1989 Angell Report on Netting Schemes
Noels 1993 Central Bank Payment and Settlement Services
with respect to Cross-Border and Multi-Currency Transactions
The 1996 Allsopp Report entitled Settlement Risk in Foreign
Exchange Transactions
In 1996, a study by the G10 central banks found that banks
foreign exchange settlement exposures to their counterparties
were in many cases extremely large relative to their capital,
lasted overnight or longer, and were poorly understood and
controlled. To try and resolve these issues, the G10 launched
a high-profle project to tackle the issue of FX settlement risk
by devising a strategy to improve the understanding and
management of settlement risk, as well as reduce the systemic
risk arising from the settlement of foreign exchange trades.
he |ermcIen cnd sgnhccnce e| C|5
Following the 1996 study, the G10 member banks agreed to
the continuous linked settlement concept, which allowed for
the simultaneous exchange of currencies and thus eliminated
settlement risk. In 1997, the banks launched CLS Services, a
private, not-for-proft group owned by major trading banks and
brokers, with the aim of developing a specialist bank to handle
settlement processing. CLS Bank was launched fve years later
and is based in New York. It settles foreign exchange fows for
CLS members, their customers, and other third parties.
Over the past fve years, CLS Bank has had a wide and positive
effect on the FX trading community. It has completely eliminated
settlement risk on the FX trades it processes.
OPtimizing Settlement riSk mAnAgement: ClS And beyOnd
tHe ClS PrOCeSS And itS eFFeCt On FX trAding
CLS follows a well-defned set of processes. A single multi-currency account is created for
each settlement member. Accounts are credited when funding pay-in occurs and debited
when funding pays out. Each member has its own account with CLS Bank from which it
sends and receives currency payments. Members submit their instructions details of
payments in specifed currencies to CLS on a daily basis. Before daily settlement
commences, CLS provides the net cash position to each member and ensures that all
instructions meet its stringent settlement criteria. Pairs of instructions are then matched up
and funded before the trade execution itself, where payments are made in the specifed
currencies. These processes occur on the trade date, in real time and on a continuous basis.
With CLS, banks make payments on the net position of each currency, rather than on a
gross transaction-by-transaction basis. This reduces the funding necessary for individual
transactions by up to 90%. For example, according to the Economist, a single payment
[to CLS] of a few million dollars, yen or euro is enough to settle a banks multiple trades
scheduled in that currency for that day, even though their gross value may be hundreds of
millions of dollars.
This has helped promote the increase in trading that has shaped the
FX market over the past fve years.
As well as eliminating settlement risk, CLS also delivers real-time settlement information
that helps members to manage liquidity more effciently, reduce credit risks and increase
operational effciency.
CLS has helped banks in a number of ways. For example, reduced exposure to FX settlement
risk helps European banks reduce their Basel II obligations. Taking advantage of a rapid,
98% reliable settlement system also helps banks improve their overall trading performance
in quality as well as volume.
tHe Current envirOnment And CHAllengeS FACed
by ClS member bAnkS
With its endorsement by the G10 central banks, CLS will continue to maintain a signifcant
role in the settlement process. In addition to the obvious benefts, however, there are a
number of drawbacks to the CLS system that hold major challenges for banks.
The frst is the fact that the elimination of settlement risk through CLS comes at a price. CLS
remains relatively expensive. The entry fees for prospective shareholder and settlement
member banks are prohibitive for all but the largest banks, while membership fees and trade
settlement costs are also high. Some banks have helped offset this cost by using their CLS
membership for revenue generation by selling third-party services. But in todays high
volume environment, using CLS remains a strain on the resources and proft margins of
many FX trading banks something they can ill afford in a market where the need to reduce
costs per trade is paramount for competitive success.
1 Plumbing Revolution The Economist,
November 15, 2002, p. 99. 7
OPtimizing Settlement riSk mAnAgement: ClS And beyOnd
The second diffculty is the fact that while CLS currently settles 55% of all FX transactions,
banks still need to fnd alternatives to mitigate their risk for the 45% that doesnt fow
through CLS.
CLS only settles in 15 currencies: US dollars, Canadian dollars, Euro, Japanese yen,
GB pound, Danish krone, Hong Kong dollars, Singapore dollars, Australian dollars, New
Zealand dollars, South African rand, Swedish krona, Swiss francs, Norwegian krone and
Korean won. As the dollar loses its grip on the world of fnance, the FX trading market is
becoming increasingly diverse, with trade volumes in currencies such as the Polish zloty
seeing a massive increase. Until CLS widens its scope, banks are faced with the diffcult
choice of either missing out on opportunities that lie in currencies not supported by CLS,
or exposing themselves to high levels of FX settlement risk.
The extensive use of algorithmic trading within the FX market also poses unique challenges
for CLS users. Because algorithmic trading generally results in high volume / low-value
trades, settling these trades through CLS may not be commercially viable in some cases
because of its relatively expensive cost-per-trade model. As the number of trade tickets
increase while the value of trades decrease, trading profts for algorithmic trading become
more and more dependent on the settlement cost-per-trade. CLS has responded
by adopting a sliding scale to its cost-per-trade model based on both trade volume and
on the value of each trade a necessary frst step to ensure the commercial viability of
algorithmic trading for its users. As algorithmic trading continues to rise going forward,
CLS will be under constant pressure regarding its settlement cost-per-trade. Banks will need
to constantly monitor the situation and have alternative solutions in place that will help them
minimize trade settlement costs while ensuring high levels of risk management.
Additionally, despite the fact that CLS eliminates trade settlement risk, it is not entirely risk-
free. The Economist claims that CLS Bank may increase a banks exposure to other risks
because the members are entirely reliant on a single entity. From an operational risk
perspective, this raises the question of what might happen if CLS Bank has a breakdown,
since even the smallest interruption of the service would be a global matter, hitting all
15 FX payment systems with a single blow
. Although these considerations in no way
undermine the success and achievements of CLS, they highlight the fact that it does not
provide a complete solution to the problem. Banks need to consider CLS as the frst step in
a much wider risk management program, and explore viable alternatives, in order to truly
eradicate FX settlement risk.
2. RMA Journal, The CLS Bank: Moving Beyond
Herstatt to Eliminate Settlement Risk Through
Continuous Linked Settlement Beverly J. Foster
OPtimizing Settlement riSk mAnAgement: ClS And beyOnd
AlternAtiveS tO ClS
The challenges and limitations of CLS highlight the fact that it is a relatively new system with
room for development. CLS will, without doubt, evolve and improve on its current model.
In fact, it is already extending its services to include non-deliverable forwards (NDFS) and
FX option premiums. But banks should also take matters into their own hands by exploring
alternative methods of dealing with FX settlement risk. In this way, banks can diversify their
approach to this kind of risk. This will not only help compensate for the shortcomings of CLS,
but will also make it easier for banks to seize opportunities in currencies and trades that are
not currently supported by this system.
8|cIerc| neIIng
A strong alternative to CLS is bilateral netting a legally enforceable arrangement between
a bank and counterparty. While multilateral netting models such as the one used by
CLS typically involve multiple parties mediated by a clearing house or central exchange,
bilateral netting only takes place between two parties. In bilateral netting, banks must agree
and draw up a contract to defne which transactions are included in the agreement. The net
worth of all transactions carried out in a single currency within a defned period can then be
settled in a single payment. This helps reduce both risk and the cost of clearing.
This contract creates a single legal obligation covering all included individual contracts.
Banks only exchange the difference between what each party owes the other. In the event
of the default or insolvency of one of the parties, their obligation is the net sum of all positive
and negative fair values of contracts included in the bilateral netting arrangement.
Cash transactions are still the majority, but more and more derivatives transactions are
bilaterally netted in todays environment. Bilateral netting currently accounts for about
US$1 trillion of trades daily.
Banks are also involved in bilateral agreements that cover cross product and cross structure
netting. As banks continue to expand their bilateral settlement agreements on a currency /
product basis, third party software vendors are developing tools to identify potential netters
and even auto-netting facilities to assist in this regard.
A number of pre-payment netting solutions have been recently launched in the marketplace.
Some of these work by receiving deals from the various dealing platforms and determine
whether or not each deal is netting-eligible based on customer-defned parameters.
Before netting, trades are matched by the system to ensure netted trades do not have to
be reopened. Banks can data-manage daily trade positions and aggregate them to fnd
their net exposure. This is then processed by the back offce. While these solutions certainly
offer added value to their bank clients, their value with regards to CLS is limited because
CLS currently only accepts deal tickets. They do not accept these netted deals as
payment records.
OPtimizing Settlement riSk mAnAgement: ClS And beyOnd
5cmedcy er nexIdcy seII|emenI
There are also opportunities for banks to increase the percentage of trades that are settled
same day or next day. The standard time for immediate settlement (usually known as the
spot value date) is two business days after the trade date (T + 2). The only exceptions to this
convention are US dollars and Canadian dollars, which have a spot value date of T + 1
because they operate within the same time zone. The conventional wisdom is that the two
business days for settlement reduces settlement risk, allowing time for deal confrmation
details and settlement system instructions to go through between counterparties. There are
many who believe, however, that immediate settlement should be shortened to just one
day for most currencies, and that in doing so, the shorter settlement period will signifcantly
decrease settlement risk.
A SyStem FOr tHe Future
Technology also plays a vital part in helping banks deal effectively with FX settlement risk.
Todays banks are under immense pressure to increase their trading volumes at the same
time as reducing operational costs and increasing profts. To achieve this, they must reduce
processing costs per trade and support their trading activity with high-performance back-
offce systems. Since one of the key pain points around CLS is its high cost, any alternative
must be supported by cost-effective technology.
Equally important is the issue of scalability. The current FX market is marked by phenomenal
growth and banks cannot afford to keep investing in new systems to cope with ever-
increasing trade volumes. By selecting back-offce technology that is capable of processing
unlimited transaction volumes, banks can safeguard themselves from back-offce
ineffciencies that might hinder their growth.
Web-enabled functionality is also crucial for back-offce systems. By exploiting web tools,
banks can shift responsibility for many non-STP processes to their customers. This fulfls two
functions. On the one hand it is advantageous to the bank, helping to reduce the cost of
some of its back-offce processes and making it easier to allocate in-house resources more
effciently. At the same time, web-enabled access to the banks back-offce system provides
customers with the increased levels of control and transparency they demand.
Research from TowerGroup predicts that in 2007, global FX daily average volumes will
exceed US$3 trillion. Banks need to ensure that their back-offce systems can cope not only
with high trade volumes, but also with the number of trade tickets that fow through the
system. Todays traders are trading smaller ticket sizes, but in much greater number of
tickets. As algorithmic trading continues to be a powerful driver in the FX market, the
volume of tickets processed will continue to grow signifcantly faster than the notional
dollar amounts traded. Electronic trading continues to grow and this year will account for
more than 44% of this volume. This trend is placing signifcant pressure on back-offce
infrastructure because of the relatively high costs associated with processing trade tickets
and trading banks must ensure that they are prepared to cope both now and in the future.
OPtimizing Settlement riSk mAnAgement: ClS And beyOnd
Clearly, todays banks cannot continue
to rely exclusively on CLS for their FX
settlement risk needs. The trade settlement
process has evolved signifcantly over the
past 30 years CLS being just the latest
stage of a much larger evolving process.
In short, banks need to implement
additional risk management strategies
that sit alongside CLS and enable
settlement across all FX trades and
all currencies, as well as being more
accessible to smaller banks.
By establishing such a framework of
alternative strategies including bilateral
netting and same-day or next-day
settlements banks can create a more
effective, fexible settlement strategy
while removing the risk of dealing with
a single entity.
Banks are already investigating lower cost
alternatives to CLS. The emergence of
viable alternatives will create a competitive
atmosphere, which will eventually drive
down the cost of settlement per trade from
dollars, to cents, to basis points. Some CLS
shareholders are already using CLS purely
to mitigate settlement risk and choosing
bilateral netting to produce payment
instructions. Other banks will follow suit,
which may have an impact on CLS in
the future.
Crucially, it is the technology a bank
uses that will make these efforts successful.
To effciently and cost effectively deal
with FX settlement risk, banks will need to
implement powerful back-offce systems
that can cope with high volumes of
transactions and trade tickets, and support
connections to the multiple settlement
systems that exist in the marketplace.
2007 Wall Street Systems Delaware, Inc.
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