CLS: can’t live with ’em, can’t live without ’em?

FX settlement giant not fast on its feet, say dealers and challengers, but hard to knock down

Montage: FX Markets

  • In late 2019, the Bank for International Settlements warned that the FX market was becoming more exposed to settlement risk and encouraged participants to use payment-versus-payment settlement, where available.
  • CLS is the acknowledged industry utility for this mutual settlement method. Users praise its efficiency and say it greatly reduces settlement risk for eligible trades and participants.
  • But, while effective at reducing settlement risk, CLS’s success is not unalloyed. Its legal foundations mean not all market participants are eligible to join. Banks can onboard clients as third parties, but this solution has its own risks.
  • Dealers say it has been slow to move towards emerging market currencies that are a growing feature of FX markets, thus failing to capture an increasingly large portion of FX settlement risk.
  • CLS is addressing these concerns within its legal and regulatory constraints and has proposed a second tier of membership for emerging market trades to watching regulators.
  • Meanwhile, alternative solutions are coming to market to plug perceived gaps in the CLS defence. So far, at least, their services appear to be complementary.

CLS, the foreign exchange settlement colossus, is purpose-built to battle settlement risk and, since its creation, has provided the go-to defence against it. But the evolution of FX markets has left the utility giant looking leaden – and ill-equipped to tackle a more diverse universe of currencies and trading partners.

The growing relevance to the FX space of fragmented liquidity and emerging market currencies has pulled focus onto the rise of settlement risk – the danger that a firm pays a currency it has sold, but fails to receive a currency it has bought. And while it is widely acknowledged that CLS performs this critical task effectively, its sluggishness in squaring up to developing industry trends is fostering dissatisfaction in those who rely on it.

“Nobody really likes CLS – but we can’t live without it,” says the global head of e-FX at one US dealer. He concedes: “It’s here to stay because there’s nothing better or even similar out there.”

CLS chief executive Marc Bayle de Jessé acknowledges these issues and insists the utility is working hard to address them. 

“While volumes in CLSSettlement have increased in the 18 currencies we settle, we are working with the FX industry and regulators to raise awareness of the wider problem of rising FX settlement risk and to develop a solution to this industry challenge,” he says.

CLS recently proposed a stripped-back service for EM currencies and has been pushing its third-party services for non-members. 

Some still question whether the utility can keep pace with market developments. They say the settlement process would benefit from an improved, streamlined structure, able to welcome more members.

“At the moment, everything is concentrated in the hands of a very small number of parties, compared to the number of people trading FX every day,” says Luke White, head of FX prime brokerage for Emea at Societe Generale. “But if you open up, you get a democratisation of the FX market, whereby corporates and others can settle without the need to go through a bank or a prime broker.” 

And because growing numbers of new currencies and participants are not fully represented on the utility, the number of transactions settled on it is shrinking as a proportion of all trades.

In December 2019, the Bank for International Settlements’ (BIS) triennial survey showed that in FX, nearly half of daily gross payment obligations – $8.9 trillion of $18.7 trillion – were settled without payment-versus-payment (PvP) protection (see figure 1). 

“It's the currencies that have grown more in the recent past that would benefit from being within CLS,” says Ian Downes, head of post-trade business development at BBVA. But liquidity rules have prevented some of these currencies from joining, he notes.



Growth in emerging market currencies has outstripped growth in more traditional currencies and many of these currencies are not CLS-eligible. Turnover in the most active non-CLS EM currencies – such as the Indian rupee (+115%), Philippine peso (+138%), Taiwanese dollar (+150%) and Indonesian rupiah (+200%) – has led the proportion of PvP settlement in CLS currencies to slip to 40% in 2019 from 50% in 2013, according to the BIS.

“Although CLS has evolved significantly through the years, it can be a little clunky at times in the way it approaches things,” says the global head of e-FX. “When only one third of executions are going through, you have a bit of an issue.”

The arrival of challengers in the space could make inroads into the utility’s dominance – or fill in some of the perceived gaps (see box: Challenging – or complementing?).

When only one third of executions are going through, you have a bit of an issue
Global head of e-FX at a US dealer

“Settlement risk is a challenge for everyone in the FX market and you need innovation and outside involvement to bring new options and new possibilities,” says BBVA’s Downes. “There are a couple of smaller companies trying to enter the space, who are looking at settlement risk from a slightly different perspective, in particular at possible technological solutions.”

Still, some bright spots demonstrate why CLS has retained its dominance for more than 15 years. Participants say it is especially critical during times of market stress and are keen to praise its performance during the early stages of Covid-19.

“CLS was functioning well – the volumes they put through in February and March were pretty big and a sign there were no issues,” says the global head of services operations at a large bank.

In fact, average daily traded volume submitted to CLS hit an all-time high of $2.2 trillion in March – 14% higher than the previous record of $1.9 trillion set in February 2018. Since then, volumes have subsided a little, but remain in line with previous months (see figure 2).



“That's probably one of the things which makes everybody who uses CLS appreciate it,” says the services operations head. “From a settlement risk perspective, you have no failure, they are operationally efficient and they can massively reduce your risk and your funding requirements.”

Emerging plans

In December 2019, the BIS warned that the FX market was becoming more exposed to settlement risk. It encouraged market participants to use PvP, where available, and to expand this availability to EM currencies. 

Accordingly, the market began to take stock of where any gaps might be, how they can be closed and who should take on the challenge.

The issue is being explored by the Global Foreign Exchange Committee, the industry body tasked to oversee currency markets, as part of its triennial review of the FX Global Code. And at the July meeting of the New York Fed’s FX committee, CLS presented a proposal to create a stripped-back system for EM currencies that are currently CLS-ineligible as part of this examination (see box: Strengthening the FX Code).

Under that stripped-down structure, EM currency netting would be settled on a single-pair basis only – not multi-pair, as currently used for CLS-settled currencies.

"If settlement risk in non-CLS currencies is to be mitigated, a fundamental consideration is whether an alternative model that provides a form of PvP protection is better than the outright risk that is taken today in trading these currency pairs,” says Bayle de Jessé.

Practitioners say the prospect of this simplified approach is a step in the right direction to reduce settlement risk in EM currencies.

“Those currencies tend to be the ones where there is more risk,” says the global head of services operations. “If CLS were able to do something more quickly around these, it would reduce a lot of pain for the market, and we would certainly be interested in seeing non-CLS currencies becoming part of the system somehow.”

EM currencies grew nearly twice as fast as their G10 counterparts between 2016 and 2019, according to the BIS (see figure 3).



“Although most of these currencies are not a big part of the market in terms of volumes, you have pairs like USD/CNH, which have become much more actively traded recently,” says the  global head of e-FX. “While this doesn’t explain the full gap, CLS not covering some of these EM currencies is playing a big part.” 

Meanwhile, the share of total turnover for CLS-ineligible currencies has jumped from 14% ($800 billion) in 2013 to more than 18% ($1.25 trillion) in 2019 (see figure 4).



Since many of these currencies are not yet part of the CLS universe, their growth amplifies overall settlement risk.

A two-tier system would also mitigate the complex onboarding process currently in place for a currency to become CLS-eligible. This revolves around five eligibility criteria, ranging from domestic support to operational and technical requirements, including the existence of a real-time gross settlement system.

While the newly proposed system would simplify this process, netting efficiencies for that single pair would be significantly lower than if it were part of a multi-pair run and, accordingly, the reduction in funding requirements for users would be smaller. 

CLS says its clients see their funding requirements cut by 96% or more through multi-pair netting. A user’s US dollar obligations, for instance, could net down to a single payment across all trades against the currency, whereas single-pair netting, also known as bilateral netting, is said to achieve reductions of between 60% and 70%.

It’s not you, it’s me

Despite these ongoing efforts, some dealers still see CLS as being slow to adapt to changes in the FX space. They point to other flaws of adaptability, including the membership process.

“If I’m a CLS member and a client of mine isn’t, then I have to do that trade outside of CLS, which isn’t great,” says the global head of services operations. “Sure, I could introduce a corporate under my membership as a third-party participant, but then I would be completely responsible for all of their activity, which from a risk standpoint is not something I would want to take on.”

The head of prime brokerage and clearing at another large bank echoes this view, and says settlement risk is now on the radar of a more diverse universe of market participants, such as proprietary trading firms and hedge funds.

“Not only are you seeing the expansion of settlement risk beyond the banks, you’re seeing an increase in the notional value of contracts going to settlement among this group of new market participants, which results in an amplification of delivery risk outside the controlled CLS settlement environment. I absolutely think the CLS membership needs to be expanded.”

The membership issue does not only revolve around corporates and hedge funds. With the FX market becoming more complex and fragmented over the years, new liquidity providers have entered the scene and some of them bemoan the barriers to full CLS membership.

When it comes to membership, a part of the equation is prescribed by CLS, but by far the most important factor is that CLS functions as it does with full protection of participants
Alan Marquard, CLS

“If we are dealing with systemic risk across multiple different organisations and liquidity has diversified in the industry, then CLS membership needs to become easier,” says the head of e-FX at a non-bank. “There are certain requirements in place that are more challenging for a non-bank to achieve. As long as these requirements are in place, we won’t try to become members.” 

Current CLS members say the industry faces a balancing act between allowing for less restrictive entry criteria and reducing the amount of settlement risk in the market. If entry requirements were to be revised, the benefits would outweigh the risks, they say. 

“Having settlement lines and delivery limits with firms that become insolvent before they deliver their side of a trade is infinitely more risky than allowing them to become members by tweaking the membership requirements – as long as the pre-funding requirement is maintained,” says the head of prime brokerage and clearing.

But CLS’s hands are tied. It has very little power to change who can become a member, because this is set by the EU’s settlement finality directive (SFD). Adopted in May 1998, this regulates the systems used to transfer financial instruments and payments, including CLS. 

Alan Marquard

“When it comes to eligibility for CLSSettlement membership, a part of the equation is prescribed by CLS, but by far the most important factor is that the service functions as it does with settlement finality and full protection of participants because of the legal framework under which it operates,” says Alan Marquard, chief business development officer at CLS.

He explains that for the multilateral netting algorithm to be functional and enforceable among participants, its governing law must be recognised by all participants’ jurisdictions and must recognise all participants.

“The Settlement Finality Regulations (the UK implementation of the EU SFD) only allow certain types of entities to qualify as participants in CLSSettlement to ensure there is no adverse negative impact to those participants, as well as the service itself,” says Marquard.

In its current version, the SFD does not include firms such as non-bank liquidity providers and corporates. Any change to the SFD to allow for different and new types of entities to become CLS members would require the European Commission to put forward legislation amending it. The European Parliament and the Council would then propose their own version of the text and, only when the three bodies reached agreement, could changes be made to the directive.

“We cannot widen membership to CLSSettlement beyond those defined categories as the rules are implemented under the law,” explains Marquard. “We're aware that there is an appetite for a broader set of participants to get direct access to CLS, but the reality is that for most centralised infrastructures that concentrate risk, including payment systems to operate effectively and safely, there need to be strict criteria for direct membership in order to protect the safety and efficiency of the system, its members and the global financial system.”

While changes to the SFD are not part of the Commission’s upcoming legislative agenda, FX Markets understands a public consultation on the subject is due to be launched in the coming weeks. A spokesperson for the Commission declined to comment.

Back to basics

When it was established in 2002, CLS began settling FX payment instructions for 39 members in seven currencies. In CLSSettlement, the utility’s main service, CLS created a PvP system that guarantees each counterparty receives the currencies they have bought and sold.  

PvP ensures the final transfer of a currency payment occurs if – and only if – the final payment in its pair takes place. When an FX trade is executed by a member or a third-party participant, CLS receives an electronic payment instruction for both counterparties. Once the system has authenticated and matched the information, it stores the payment instructions until settlement day, when it simultaneously settles each pair involved in the trade.

We have a systemic responsibility to make sure that all users of the market actually understand that we’re there and understand the benefits of using us
Alan Marquard, CLS

Regulated by the Federal Reserve, CLS is supervised by an oversight committee of 23 members who represent 18 CLS-eligible currencies plus five additional Eurosystem central banks. It has grown to accommodate 73 members and almost 28,000 third-party participants, which access its services by paying the direct members. It now settles those 18 eligible currencies, and expects to add the Chilean peso in the next 18 months.

Further offerings include CLSClearedFX, which focuses on over-the-counter cleared FX derivatives, and in July 2019 the firm added a bilateral same-day PvP settlement service. Unlike CLSSettlement, where trades are matched and netted on a multilateral basis at the start of the trading day, CLSNow allows parties to determine at what point in the day they want their trades to settle, allowing flexibility in liquidity management. Currently covering US dollar, euro, sterling and Canadian dollar settlement, five institutions are onboarding the service.

To become a CLS member, a financial institution must satisfy a number of operational, technical and financial criteria, including the ability to manage payment instructions on the system; to deliver funds in each eligible currency within specified times; and to have contingency plans for maintaining operational capabilities.

They must meet the minimum capital and capital ratio requirements imposed by their primary regulator and have a minimum long-term credit rating of at least BB-.

Moreover, they must be in a jurisdiction for which CLS has received a satisfactory legal opinion addressing settlement finality and netting. Lastly, they must have anti-money laundering procedures in place.

Practitioners say removing or lowering some of these criteria – where practicable – could be a step in the right direction for a wider membership.

Third-party pipeline

In the meantime, the closest thing to achieving a wider membership is the third-party partnership CLS is offering to non-members. Roughly a third of CLS members are providing this service, with more set to join. 

“A few years ago, we recognised the importance of growing the third-party community. We have engaged with asset managers, hedge funds and corporates because we think we have a systemic responsibility to FX market participants to ensure they are aware of settlement risk and understand how they can mitigate it through CLSSettlement. This is in addition to the wider benefits of the service, such as reducing funding costs by 99% through multilateral netting,” Marquard says.

Theoretically, the service allows for the onboarding of thousands of firms per service provider, a practice that has raised concerns around the concentration risk that could materialise if a CLS member onboards too many third-party institutions. 

Marquard admits concentration risk can occur but emphasises its preferability to the alternative.

There are some capacity and cost constraints associated with the third-party access
Head of prime brokerage and clearing at a large bank

Concerns have also been raised on whether third-party providers can sustain infinite growth of the service. 

“I do think there are some capacity and cost constraints associated with the third-party access,” says the head of prime brokerage and clearing. “Not many banks have invested in the offering in any meaningful way, so there’s obviously going to be a finite amount of capacity to bring on new accounts, which could result in an increased cost structure.”

But Marquard is not buying the argument: “Settlement members that do offer third-party services have risk management frameworks in place to monitor and mitigate their respective counterparty, market and operational risks associated with the service offering.

“We conduct due diligence of our settlement members at onboarding and monitor their financial risk profile and capital levels, one of the eligibility criteria, on an ongoing basis to ensure that members can adhere to our requirements,” he adds.   

Despite the brickbats, it seems many FX market participants can – and will continue to – live with CLS. 

Challenging – or complementing?

Potential challengers to the CLS model have entered the FX post-trade and settlement arena in recent years with new and different approaches.

Among these is Baton, a California-based technology firm, which has been developing a series of liquidity management tools to enable counterparties to make flexible payments to each other – either by splitting them up or making them conditional on certain trigger events.

The system uses distributed ledger technology (DLT) to create a single, shared record of transactions and aims to provide near-real-time settlement for emerging and frontier currencies, where a lack of liquidity can often make traditional PvP systems unviable.

Other initiatives include R3, a consortium of financial firms exploring blockchain and distributed ledgers in its work on smart contracts, and London-based Cobalt, which uses DLT for its FX post-trade platform.

Its proponents say a DLT structure such as Cobalt could lead to a saving of 80% in back-office costs by moving away from multiple layers of trade reconciliation and adopting a shared ledger to reconcile FX transactions instead.

“Baton and Cobalt are very interesting propositions, but they haven’t firmly caught on yet because of the challenge of getting scale and having enough members onboard,” says the global head of e-FX. “While CLS has 70 or so large banks behind them, those two firms need that network effect for it to work, and they’re not there yet.”

Wider adoption of these new solutions might be even harder to achieve without the full backing of the banks.

“How comfortable would banks be, using a new infrastructure when they’ve got something that works effectively today, reducing both the risk and the liquidity needs?” says the global head of services operations. “It would have to be something quite unique to come in and take CLS down, and I would be surprised if something can replace it.”

The hardest part in attempting to enter the settlement space is providing the same “comfort that everything is going to be fine on settlement day,” as only CLS currently does, he adds.

Which is why, some argue, it makes more sense for these new entrants to work alongside, not against CLS. 

“CLS is an industry utility where the banks sit on its board. It’s almost impossible to implement new solutions system-wide without the connivance of those banks,” says a senior analyst at a US consultancy firm. “So, it might be easier for those firms to shift their focus on becoming efficiency tools for the banks rather than directly competing with CLS.”

This view is shared by Arjun Jayaram, founder and chief executive of Baton, who says the FX market is large enough to allow for different solutions to co-exist.

“If both parties are on CLS and they agree that that is how they want to settle a trade, then CLS is the ideal settlement venue and Baton would route that settlement over to CLS,” says Jayaram. “But in many cases that may not be an option, because either one of the currencies is a non-CLS currency or one of the parties is not a CLS member, and that’s when Baton can come into play.”

While Jayaram acknowledges that “strong governance and the regulatory friendliness” make CLS almost impossible to replace, the advent of synthetic products and digital assets that will need to be cleared and settled will allow room for Baton and others to build new solutions in the future.


Strengthening the FX Code

During the July 15 meeting of the New York Fed’s FX committee, participants discussed the possibility of strengthening principles 35 and 50 in the FX Global Code, relating to the management and reduction of FX settlement risk as part of the GFXC’s triennial review of the code. 

During the meeting, Lawrence Sweet, a senior vice-president at the Federal Reserve Bank of New York, said “such strengthening could reflect industry perspectives on the challenges and opportunities for increasing the use of PvP when available, and for promoting the appropriate measurement and control of FX settlement risk when PvP is not used”. 

Principle 35 states that market participants “should take prudent measures to manage and reduce their settlement risks, including prompt resolution measures to minimise disruption to trading activities”, while principle 50 says market participants “should measure and monitor their settlement risk and seek to mitigate that risk when possible”.

The GFXC encouraged signatories to consider payment netting and bilateral obligation netting where possible. It added that the process of settling payments on a net basis – either bilaterally or multilaterally – should be supported by the appropriate bilateral documentation. 

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