CLS settlement: the challenges ahead

Despite showing its resilience relative to the wider financial markets, the foreign exchange industry is not without its challenges. The collapse of major liquidity providers last year underscored the need to remain vigilant as counterparty and settlement risk took centre stage. As risk is re-priced to more accurately reflect counterparty, settlement and operational exposures compounded by a tighter regulatory environment, a question has emerged over what role CLS can play.

FX Week: What has been the biggest development in the FX market in the past 12 months and what were the implications for CLS?

Rob Close: Few people will forget the collapse of Lehman Brothers, as it happened during Sibos last year, and the extraordinary market developments that ensued. The ramifications were felt across all asset classes, intensifying the focus on credit and risk management in many forms.

For the FX market, it was no different, and with the management of settlement risk being propelled to the top of the agenda, it was the sternest of tests for CLS. By delivering orderly settlement of all submitted trades from Lehman Brothers, and simultaneously setting a new record for the volume settled in a single day on September 17, the participants gained the certainty the service was designed to deliver.

The events of last September certainly put the settlement of the multi-trillion dollar FX industry at front of mind and the resulting wider CLS participation has been very encouraging. There is still more to do.

FX Week: Has the recent crisis affected take-up of CLS in the Asia-Pacific?

Rob Close: We have been receiving record levels of enquiries about CLS participation globally. The Asia-Pacific region continues to be an important part of the FX market in which CLS is active (settling six regional currencies).

We work closely with market participants and increasingly the FX committees in the region to raise awareness of settlement risk and the role CLS plays, so we're delighted Sibos has come to Hong Kong this year, to facilitate that process.

FX Week: At the end of last year, CLS embarked on a programme to review its participation model, to cater for more institutions through the direct-bank and third-party models. What is being done to extend CLS services to non-CLS participants, currencies and products?

Rob Close: We have conducted two reviews with our third-party distributor banks since the Lehman failure. Clearly credit has got tighter, and terms and conditions have been reviewed. Arguably these elements were underpriced historically and clearly not just for FX. Overall, we were assured the third-party model was effective. Trading and clearing relationships include the extension of credit. The fact these have been throttled back is no surprise and equally it is for every bank to establish its limits. I think the progressive reduction in leverage in hedge funds will be a bigger overall change than the credit reviews in the bank segment.

FX Week: The collapse of banks in the US and Europe, led by the default of Lehman Brothers last September, proved CLS was able to eliminate Herstatt risk. However, third-party CLS providers can be exposed to replacement and intraday funding risks at times of crisis. How is CLS helping third-party CLS providers mitigate these risks?

Rob Close: A good question, but one with no single 'silver bullet' solution. Our working groups indicate that getting any significant non-participants into CLS is still the number one priority. The multilateral netting algorithm has been tuned and netting efficiencies have continued to edge up, small improvements translate into significant money. Of course, we continue to work on adding currencies, which, as you know, is complex in each case. We plan to engage with the CLS nostro providers to establish best practice improvements in recycling CLS-related funds.

Replacement risk protection for short-dated deals, particularly spot trades, is generally seen as neither necessary nor cost effective. For longer-dated transactions debate has started and the first policy choice is whether this is mandated or voluntary, which is being discussed right now. The margin costs for clearing are not known, which leads many participants to prefer a voluntary solution to provide the choice or option dependent on their credit appraisal of the counterparty. The providers have other remedies in terms of pre-funding and collateral as applied in many trading relationships.

FX Week: What reforms are being made to the application of in/out swaps, which have been shown to expose CLS members to liquidity and settlement risks in the out leg of the swap?

Rob Close: Not exactly a new issue. The first element has been to attract further in/out swap participants to generate the largest range of swap opportunities for members to elect to trade. We have a manual settlement alternative for the out leg if the market faces stress at some point. We are progressing with the development of an automated production system as part of the development of same-day settlement.

FX Week: Can you describe exactly how the CLS-Traiana joint venture works and what the cost structure is for founding members and then participants?

Rob Close: CLS Aggregation will be offered and operated by a CLS Bank subsidiary, which is 51% owned by CLS and 49% by Traiana/Icap. The subsidiary will have its own board, chaired by the CLS CEO and including directors from the user community and the CEO of Traiana. It is not appropriate for me to comment further on the costs at this time. However, the pricing structure of the service will be fully compatible with the new CLS pricing model. The JV will provide the trade aggregation service, aggregating, on a regular basis, all the buys and sells a bank has with its counterparty in a particular currency pair. This will mean it is only the aggregated trade that has to be processed by the bank's systems, and it is the aggregated trade that will be settled in CLS.

The service will reduce the operating risk and the operating costs of FX post-trade settlement as well as relieving pressure on back-office systems. Eight banks have indicated their intention to participate, which is gratifying. The service initially covers the G-7 currencies.

FX Week: CLS's business model used to be one of high fixed costs and low marginal costs, while its strategy has been to get variable revenue from FX and slowly expand into adjacent asset classes. How has this evolved?

Rob Close: The cost dynamics you describe remain, as does the strategy to be the industry choice for co-operative solutions for FX post-trade efficiencies and settlement services - the one-stop shop for FX. The dynamic nature of the FX market led us to conclude the CLS Aggregation deal and service. Several of our earlier initiatives: currencies, same-day settlement, Fund FX, continue as before although the change in the credit climate is accelerating growth in participation.

The change in the regulatory landscape will deliver, no doubt, new challenges and requirements. We are heavily engaged with many groups in these discussions. We have, however, been assured that as these changes play out our members want us to be at the heart of any new infrastructure initiatives.

FX Week: The US OTC Derivatives Markets Act was presented to Congress on August 11. It says the exact definition of OTC derivatives will be made by the SEC and CFTC within 180 days after it is passed, but says clearly that they will have to be cleared through a "derivatives clearing organisation registered under this Act". It also requires that the SEC/CFTC "shall jointly define the term 'standardised' as broadly as possible". This surely poses a threat to CLS expansion, both directly in terms of CLS's ability to expand into other instruments and indirectly in FX that is a consequence of derivatives. Will CLS try to register as a derivatives clearing organisation in the US?

Rob Close: There is still a deal to be done to define what does or does not fall into the definition of a derivative for FX in the US. In Europe too this is not clear. The FX market is distinctly different from the rates, equities and commodities markets and is one used by a vast array of users daily for different purposes and reasons. We would maintain a 'one-size-fits-all' clearing structure needs consideration of the effects on the broader commercial sector as well as the financial one. Clearing does not obviate the need to settle. We are in dialogue with an array of parties as this debate evolves.

CLS is at the heart of credit derivatives clearing and already settles for ICE and shortly for Eurex-cleared credit derivatives through its partnership with DTCC. All of us are re-appraising our plans as the central counterparty (CCP)/clearing geography is in a state of considerable flux. It might not be the most popular time to remind everyone that a multiplicity of new clearing arrangements will be costly to build and operate and in FX will potentially increase the cost to trade for everyone versus the two- to five-pip bid offer spread they are used to.

FX Week: An effect of clearing is that it tends to attract other instruments to the same clearing house because of the ability to cross-margin. If a clearing house clears FX options (which appears to be included in the Act) there could be an incentive to put FX forwards there as well. Is this a threat?

Rob Close: Good point, and a marketing point for several CCPs. Settlement will still be required to be effected. The OTC market has grown in part due to its flexibility - in FX, currency pair amount and tenor are close to infinitely variable. There is still a lot to be concluded as to what is a standardised contract for novation by a CCP. The corporate sector is as concerned about cost and flexibility in CCPs, as are the banks. It is not clear where the lines will be drawn though the direction is set. If nothing else it will be a busy time.

FX Week: How does CLS regard the LCH-Clearnet and rumoured CME clearing initiatives in FX (which differ to FXMarketSpace, which failed more because it was a venue)?

Rob Close: CLS continually engages in dialogue with its members and the broader industry to support the evolution of the FX market. If the market decides these clearing initiatives are required, CLS and the members would expect us to be in the thick of these discussions due to our settlement risk elimination credentials.

FX Week: How will a clearing system work alongside existing CLS settlement processes? What are the technical, cost and legal requirements of this?

Rob Close: Industry discussions on clearing are at a research and development stage around what is required and the operational details of the solutions. The legal precedents for novation are there, although the number of jurisdictions where they are effective will probably need re-visiting given the global nature of this market. Margin costs and procedures will be new to many and will no doubt require the most discussion.

FX Week: In the UK, the Turner Report recommended strengthening bank's reserve requirements and more directly limiting the risk banks can take trading. Will this affect volumes for CLS? It's hard to see any way it could be positive.

Rob Close: Whether or not volumes are affected remains to be seen. I do not think the banks are keeping large open positions in currencies, that is an old and discredited model for banks and many other traders. Most activity is in flow trading in standard FX and that is a lower-risk activity.

We are at the first anniversary of the demise of Lehman Brothers and one of the largest shake-ups ever seen. Volumes and values are back above the early part of 2008. This market has proved amazingly durable. CLS remains focused on providing effective risk management to the industry and regardless of value and volume, the elimination of operational and settlement risk remain the highest priorities for the industry.

FX Week: In his recent interview with Prospect magazine Adair Turner suggested discussion of a 'Tobin tax' on financial transactions. It could be an idea that has political appeal. This would surely affect volumes overall, on which CLS depends.

Rob Close: It is not a new idea, although the original construct proposed by James Tobin has been re-cast in the piece you refer to. There is nothing I would want to add at this time.

FX Week: Turner also described the current situation as "a fairly complete train wreck of a predominant theory of economics and finance" and it's fairly clear the mood is towards greater controls, even if not a Tobin tax. Is there anything good in these proposals for CLS?

Rob Close: The proposals are still evolving. We have got significant credit for the role we have and continue to play. We are engaged in discussions on clearing, we also have the largest information repository for FX. We have cash-settlement services for non-deliverable forwards and currency options over and above spot, swaps and forwards. We think there are some interesting opportunities for the industry to further leverage this company it owns.

Our mandate has always been to provide collective or community services. We think there will be new and exciting opportunities.

FX Week: It's only recently that the FX market experienced a 30% downturn in volumes - between 1998 and 2001 - essentially due to political changes (disappearance of legacy currencies). If there were a similar decrease again for regulatory and other reasons, what would it do to CLS?

Rob Close: The FX market has evolved beyond measure from a decade ago and while it is not unimaginable to foresee a sustained decline in volumes so far this year they have returned to the volumes and values we saw in early 2008. We have consistently planned for conservative levels of growth financially while ensuring we have the operational capacity for the surges in volumes that can occur. This will continue to be our stance. The continued growth in participation is also a mitigating factor to an overall volume decline.

FX Week: It could be argued clearing might remove risk from the system and venues such as EBS and Reuters would manage. Unless CLS becomes a clearing house, it might be boxed in, as it can't expand into new areas and core areas might suffer a drop in volume. How is CLS preparing for this risk?

Rob Close: If the market decides clearing houses are required, it is logical and appropriate for CLS to be involved in discussions and solutions for the broader adoption of clearing. Settlement risk remains by far the largest risk element in FX. We are also exploring other alternatives for post-trade services. It is premature to discuss these now given the still rapidly evolving regulatory debate on the future shape of the post-trade world for derivatives generally and FX derivatives in our case specifically.