Frances Maguire
Frances Maguire

e-FX Industry Report : CLS - responding to the new high frequency FX trading environment

CLS recently saw record volumes and the need to temporarily extend its opening hours in response to the credit crisis. Frances Maguire asks which way forward for CLS as high frequency trading continues to grow.

Just a month short of its 5th birthday, CLS saw record volumes and the need to temporarily extend its opening hours in response to the credit crisis. Frances Maguire asks which way forward for CLS as high frequency trading continues to grow?

In just five years CLS has become an integrated necessity to the FX markets, albeit an expensive one. Arguably, it has even been the main contributor to the growth of FX business as the removal of settlement risk has enabled banks and prime brokers to extend credit lines to new and smaller entrants they would perhaps would not have done business with pre-CLS.

However, it seems that CLS is now at a crossroads and the direction it takes now will decide whether it enables or hinders further growth as the industry grapples with the need to substantially increase capacity and scale up operations for the future.

Jonathan Butterfield, executive vice-president, marketing and communication, of CLS, says that as a result of the volatility in August all CLS member banks got a significant price reduction. “We look at the total volume of CLS and the individual banks’ volume and get a unit price. Currently CLS settles around $3.5-4 trillion a day.

While some quarters of the FX industry believe that CLS is too expensive, Butterfield says that as the volumes grow, the prices go down. He also adds that the cost base of CLS is fixed so CLS is reducing its overheads by diversifying the products that it cash settles, such as NDFs, credit defaults, currency options, credit derivatives and their cash flows, which will drive prices down further. He says: “We are constantly examining pricing as a reduction will help to keep our member banks engaged and committed. The industry is paying around 15 cents a million at current volume and value levels. If there is one pip per trade spread then for a one million round lot trade then these trades generate $100. At these levels I would hope we are not the difference between profitability or the lack of it.”

Jonathan Butterfield

Jonathan Butterfield

Credit derivatives and NDFs are in trial. The settlement of currency options premiums will come in the middle of next year, when the number of currencies settled will also be increased to 17. The launch of NDFs will help banks, funds and corporates hedge in 48 reference currencies that are not deliverable. But Butterfield adds that now the major currencies are settled in CLS, there are a finite number of further currencies of interest to the members and with sufficient volumes to justify the investment. “Over the next two or three years, CLS will most likely add another two or three more currencies, with a further two in the following two years. The most important currencies to be added in the future are the “BRIC” currencies and selected other Asian and European currencies.

Martin Spurr, head of Integrated Treasury Solutions at The Royal Bank of Scotland (RBS) says that CLS has established itself as the FX industry’s chosen settlement system after a painful, and somewhat expensive, birth. It has also proven its ability to manage the rapidly increasing volumes and notional value of currencies trading in the market. “This has certainly been a source of considerable comfort to both the industry regulators and banks and positions CLS well for the future but it cannot, and must not, rest on its laurels.”

High frequency trading

The emergence and rapid growth of the high frequency trading market has challenged a number of different facets of the market, including CLS.  RBS is at the forefront of bank high frequency trading and market making and is investing throughout its business accordingly. 

Martin Spurr

Martin Spurr

Spurr believes that one of the main characteristics of high frequency trading is the changing profile of trades executed.  High frequency trading typically generates many thousands of low value tickets as it uses advanced technologies to capture the smallest of individual trade margins.  CLS, on the other hand, was originally built to provide certainty of settlement for high value trading activities.  “High frequency trading will therefore naturally challenge both the capacity and cost structure of CLS and it is pleasing to see that CLS appears to have managed successfully through the recent peaks of market activity and growth.  CLS has also re-asserted its raison d'etra during the more recent credit and liquidity squeeze.”

According to Spurr, the obvious solution for the high frequency trading market is for CLS to allow pre-settlement netting, and if this can be achieved at the lowest cost and within the auspices of CLS then better still.  He adds: “Another potential solution would be to segregate the low value tickets completely from the core CLS process and look to create a two tier pricing, systems and settlement process that reflects the tiered liquidity of the market.  Failure to address the market demand for greater efficiency will result in competing offerings such as bi-lateral netting and central counterparty models entering the market. This will increase systemic risks and/or import increased regulation.”

While he welcomes the fact CLS is looking to extend the services that it offers he cautions that CLS must not end up subsidising the lack of investment within individual banks' systems capacity and processing.  “Nobody wants to experience systemic failure and there were certainly some high profile wake-up calls handed out to individual banks,” he says.

“But CLS is an industry body and needs to focus its investment on driving for continued stability, increasing its efficiency and striving to remove its costs. Investing in IT and operational capacity within a bank is a source of competitive advantage.  Providing the markets' most assured, lowest cost settlement utility is the role that CLS is well positioned to assume but it is by no means its birthright.”

In a market where prime brokerage fees can be as low as 75p per million including CLS fees, Spurr says a CLS fee of even the lower figure of 25p per million is too high a proportion of the total cost base, particularly in the high frequency trading model, where profit per million may be below £1 per million. “The FX market is entirely fungible and will seek out the models and venues that provide the most efficient facilitation and execution of the market's trading activities.”

One of the first asset managers to participate in CLS, in December 2006, was Russell Investment Group. Russell’s manager of currency business operations, Michael DuCharme, says: “Our CLS experience has been very positive, because CLS allows us to proactively manage settlement risk.  On the day of trading or the next day, we receive a report from the custodian of our client's account, showing which deals aren't matched and ready for settlement.  Because most of our deals are related to security transactions or hedging, the trades are generally scheduled to settle at least three business days after trading.  Knowing on the trade date or the day after trading that a problem exists gives us time to call the bank and resolve the issue.”


Michael DuCharm

Michael DuCharm

DuCharme says that as CLS charges the dealing bank and custodian a fee to settle deals in CLS, investment managers, such as Russell Investment Group, have a unique opportunity to reduce risk and streamline operations, with little or no out-of-pocket costs. “Nevertheless, we're sensitive to fees that our clients must pay for currency trading, and we see net trades as one way to reduce those costs.”

However, he adds, foreign exchange volumes and transactions are growing dramatically, and he sees this rising number of transactions as an opportunity for CLS to consider netting, or reducing the fees on gross trades.

Capacity issues

CLS has begun working with banks, with capacity issues, on how to change the way they use CLS. In the future, banks could continue to submit gross trades to CLS but they would be able to aggregate trades, where bilateral trading has taken place, and only process the net economic effect of those aggregated trades.

Says Butterfield: “Some people call this netting, but the reason we do not is that you do not need an agreement with another bank to do this. Currently every trade, in each bank, goes from trade to confirmation to settlement and reconciliation. There is no need why that needs to happen three times for a spot deal – counterparty A, counterparty B and CLS. Unilateral netting is the ultimate solution to resolve the bottlenecks that banks are experiencing. The amounts netted fluctuate greatly day-to-day and CLS sees all the trades from all the banks so we can and have modelled netting efficiencies.”

Furthermore, Butterfield adds deal records are required for the regulators, so the banks cannot get away from retaining gross trade records. From a credit perspective, every bank has to start with gross for risk and positioning as the deals have to be recorded individually. Individual contracts need individual records, but the debate is on settlement of these individual trades. Butterfield says: “Our discussions started with the idea of creating a warehouse but the more we discussed setting up bilateral relationships, the less our Members liked the idea. It began to look too similar to pre-CLS days, in having to manage hundreds of bilateral netting arrangement daily. Additionally, a large portion of trades are non-nettable.

“The CLS service already adds up all trades per value date and we advise the Member banks their multi-lateral net cash exposure to the market in the 15 currencies we settle as the first step in the daily settlement cycle. The multi-lateral netting achieves massive netting efficiencies. Our model of aggregation is to retain gross input to CLS for settlement, but allows banks to individually determine the degree of deal aggregation they perform daily in terms of the volumes of trades they process through their back offices. This allows individual banks to avoid establishing and running all the bi-lateral netting agreements and associated management and maintenance of these relationships. The back office processes only the net economic effect for the aggregated trades and the gross trades where there are no offsetting trades. We think this can significantly reduce the volumes to be processed.

Some CLS members are currently carrying out feasibility studies. There is a chance this could fundamentally change processing for the large banks. “If the industry wants to change the model, we will, but they don’t,” says Butterfield. “For interbank business the banks tell us they want to stay gross. Most banks trade one way, each day, with each of their counterparties. The banks that could benefit most from netting are the largest banks, and even that varies greatly day-to-day. So far, they are really not convinced that the move to net is really going to solve everything and these programmes will add costs.

Many CLS member banks have very successful client platforms to trade FX. The largest banks are doing three times the volume with clients as they do externally so they have huge volumes that are settled internally, CLS gets the interbank volumes. They are starting to net client trades and aggregating the CLS trades will ensure banks get the maximum aggregation benefit, bilateral netting requires agreement between two banks on which pairs, how often and at what level the netting will occur, on a daily basis. Our approach will allow change to come at the individual bank’s own pace.

“There is one issue all the banks agree upon – the industry will not accept another industry level “go live” date around netting. Anything proposed has to fit into the bank’s project development processes,” says Butterfield.

Algorithmic trading

Butterfield believes the algorithmic trading in FX is a sign that the market is maturing though this development clearly poses a potential volume challenge, to banks’ clients, prime brokers and CLS. The events in August with related high trading volumes changed the horizons of the capacity needed and how quickly volumes can grow. The CLS run-rate is 500,000 to million instructions a day, but capacity back-up is always anticipated, as, since inception CLS has always experienced “double days” after US bank holidays or for the quarterly IMM settlement days.

The operational bottlenecks have arisen from the rapid growth of the FX market as new entrants look to trade FX as an asset class coupled with the increased amount of high-volume algorithmic trading. Prime brokers could not have predicted the escalation of volumes coming through the hedge funds and while they are concentrating on building credit risk systems, they need utilities to handle the settlement side of the industry.

Evolution of trade settlement

Tony White, global co-head of research and development at Wall Street Systems, says banks are already netting bilaterally and unilaterally in other asset classes and products and there is a huge amount of bilateral netting between the banks and the third parties, which are not CLS participants. Some of WSS customers have netting packages of between 10-20,000 trades daily.

In a recent white paper, entitled Optimising Settlement Risk Management: CLS and beyond, WSS outlined the challenges facing the FX industry. It says that 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 trades, because of the cost-per-trade model used by CLS, is having a negative impact on margins. As trade volumes continue their steady increase, it has never been more important for banks to develop a flexible, adaptable trade-processing infrastructure that will help them reap the greatest profit from the FX trading activity.

Tony White

Tony White

But, as White says: “The banks are wearing two hats – the risk control people, who set up CLS want nothing to change, but the people within the banks dealing with the day to day operational issues need a cost-effective, scaleable solution for the back office and are looking for relief points along the way. It is great for the FX business that there is such volatility, volume and investment in such a fast moving market but unless the market adapts, alternatives and new models will be developed.”

If ICAP is successful in becoming a recognised exchange, it will be entitled to net trades, because as an exchange it can liquidate positions. It will be interesting to see if this is ICAP’s way of tackling the scale and capacity problems the industry is facing. This could be the next chapter. If all FX deals can be netted at a regulated exchange, under a single counterparty, there would be less pressure on CLS, and it would be able to evolve into a next generation utility across all asset classes.

The WSS white paper concludes that banks cannot continue to rely exclusively on CLS for their FX settlement risk needs, and that trade settlement must evolve with the development of 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, flexible settlement strategy while removing the risk of dealing with a single entity.”

But Butterfield counters that even same day settlement would not take away settlement risk, it would simply shorten the time period of a possible failure, and that CLS will be necessary in any final solution that evolves. “Banks do not conveniently go under at the end of the trading day. In terms of settlement risk elimination the closest is a collateralised central counterparty but even that is not a full solution. If everything was netted down, the residual settlement can be significant. The only venue to eliminate that last step is CLS.”