Lisa Danino Lewis

CLSSettlement and CLSNet: Continuing to deliver huge risk mitigation and operational efficiencies

December 2022 in Supplements

Lisa Danino-Lewis, Chief Growth Officer, CLS, highlights the continued growth in CLSSettlement volumes and the increased momentum of CLSNet.

CLSSettlement is the global standard in FX settlement risk mitigation. Please remind us about how it mitigates risk and some of the efficiencies and savings it delivers.

Settlement risk is the risk that one party delivers the currency it sold but does not receive the currency it bought from its counterparty, resulting in a loss of principal. Because many currencies are paid at different times of day, there could be a significant timing gap between the payment of one currency and receipt of the counter-currency, exposing counterparties to settlement risk. CLSSettlement, a payment-versuspayment (PvP) system, mitigates this risk by simultaneously settling payment instructions relating to FX trades by ensuring the final transfer of a payment in one currency occurs only if the final transfer of a payment in the counter currency also occurs.

CLSSettlement delivers huge efficiencies and savings for CLS settlement members and their clients, maximizing the advantages of straight-through processing to deliver operational efficiencies and minimize associated costs. The service calculates the net funding required daily for each settlement member on a multilaterally netted basis; and each settlement member only transfers the net amount of its combined payment obligations in each currency, while still settling the gross value of its instructions.

This reduces the cash required to settle the payment of trades in a given day considerably, making up to 96% of cash flow available for other business operations such as trading and business growth. CLS also offers an additional liquidity management tool – in/out swaps. This, combined with multilateral netting, provides settlement members with an average funding requirement of less than 1% of the total value of payments settled. These tangible benefits have contributed to a significant growth in the values settled in CLSSettlement. Global settled values have increased 11% over the last three years, and in the first half of 2022, we had record average daily settlement values of USD6.5 trillion.

How much of the rise in CLSSettlement volumes can be attributed to third-party participants? Are there any particular sectors and regions that are driving this new business growth?

Asset managers, corporates and regional banks are significant contributors to the growth in CLSSettlement. Last year, the number of third parties using CLSSettlement increased by 25%, and third-party settled values grew nearly 10%. While we have seen an increase in adoption of CLSSettlement by the third-party community globally, there has been particularly significant growth in Asia Pacific. Last year, we saw an increase of over 40% in the number of third parties using the service in the region.

This growth has been partly driven by the Japanese fund FX program where the regulators have supported PvP settlement for FX flows. We have also focused on raising awareness of the benefits of PvP settlement throughout the region, most recently with the Australian superannuation funds.

What are the main drivers for buy-side growth and growth more generally?

Both regulators and industry participants have become increasingly concerned that FX settlement risk is increasing, given the rise in some key emerging market currencies that are not settled using PvP systems. This has heightened the focus on overall risk management, with both regulators and industry participants calling for greater adoption of PvP mechanisms.

In October 2020, the Financial Stability Board published the G20 Roadmap for Enhancing Cross-Border Payments. The Roadmap comprises a set of 19 building blocks developed in partnership with the Committee on Payments and Market Infrastructures (CPMI) and other relevant international organizations and standard-setting bodies. Building block 9 focuses on mitigating settlement risk for cross-border payments. The CPMI is exploring how to increase market adoption of PvP, either through
enhancements to existing services or the development of alternative PvP settlement mechanisms. In addition to the CPMI’s efforts, the GFXC strengthened the settlement risk principles regarding PvP and netting in its three-year review of the FX Global Code (the Code).

Greater awareness of settlement risk has helped to increase CLSSettlement third-party adoption; but for the buy side, the main driver remains the operational efficiencies that PvP settlement delivers. By using CLSSettlement, asset managers substantially reduce the resources required to manage the post-trade workflow for FX payments that are processed in the service. Additionally, PvP settlement allows them to demonstrate best practices in operations and risk management to investors. Further, asset managers have become increasingly active in the FX market as the trend toward foreign investments and hedging within portfolios continues, which has resulted in growing CLSSettlement volumes.

What other business advantages can CLS third-party participation bring?

Third parties benefit from enhanced credit efficiencies, operational risk efficiencies and expansion of their counterparty community, which can help strengthen elements of best execution through increased trading opportunities. PvP settlement also provides greater operational efficiency, as it enables trade instructions to be matched and confirmed in real time and allows users to actively manage the settlement process more effectively. CLSNet offers a standardized, automated bilateral payment netting calculation service across 120 currencies for buy-side and sell-side institutions.

What key features of the service make it so compelling?

CLSNet standardizes and automates post-trade matching and netting processes, delivering risk mitigation, liquidity optimization and operational efficiencies for currency flows outside of CLSSettlement.

While many firms have internal netting systems in place, the lack of a comprehensive service that networks across firms results in the current manual or semi-automated – but not fully straight-through processing (STP) – practice of agreeing the final netted cash flow before payment is made. CLSNet removes the requirement for manual intervention by providing full STP to the workflow. In addition to existing CLS settlement members, CLSNet allows for direct access by non-CLS banks and buy-side firms. This enables a wider group of market participants to benefit directly from the operational cost reduction and risk mitigation the service delivers, as well as supporting adherence to the FX Global Code.

How much growth has this service been experiencing and what has driven it?

CLSNet is gaining momentum, with a record USD100 billion in the average daily notional of net calculations in August 2022 (with a record USD200 billion on 21 September), and a 179% year-on-year increase in the average daily notional of net calculations in H1 2021. This growth is driven by the operational efficiencies CLSNet delivers for participants and supported by the public policy focus on mitigating risk in the FX market. We expect this growth to accelerate, and we are allocating further resources to enhance CLSNet functionality, building on the current benefits delivered by the service.

How has CLS responded to recent market developments and regulatory focus on settlement risk and how have your ideas for an alternative PvP solution been progressing?

Leveraging our unique position as the leading FX financial market infrastructure, we formed an industry working group to outline the optimal service design for an alternative PvP mechanism for non-CLS eligible currencies. We believe that success will require a public-private partnership, much like that established to create CLSSettlement. This will ensure that any resulting settlement service has wide industry support and complies with relevant regulatory standards.

The effort to develop an alternative PvP mechanism gained strong support in the industry. However, further progress depends on geopolitics, the regulatory agenda and other external factors, so this will be a longer-term solution for further settlement risk mitigation. In the meantime, for currency flows outside CLSSettlement, market participants are opting to use CLSNet – which settlement members have told us is, for now, the most effective way to improve operational efficiency and mitigate risk.