CLS already settles a vast volume of FX transactions. We spoke to its CEO, Marc Bayle de Jessé about its role and how it can help to address the rising tide of settlement risk that falls outside its current scope.
CLS’s settlement service, CLSSettlement, went live in September 2002 in the wake of a number of banking crises that exposed FX settlement risk as a significant concern. These included the collapse of Germany’s Bankhaus Herstatt in 1974, Drexel Burnham Lambert’s failure in 1990, BCCI’s a year later and Barings in 1995. Today, CLS is owned by its members, which include over 70 of the world’s largest financial institutions. Its wider ecosystem extends to over 25,000 third-party participants including banks, funds, non-bank financial institutions and multinational corporations. CLS settles 18 currencies on a payment-versus-payment (PvP) basis, totalling nearly USD6.0 trillion of payment instructions per day, yet the funding required to settle this amount is determined on a multilaterally netted basis, reducing the amount of liquidity required for settlement by approximately 96 percent.
Promoting PvP adoption
Covid-19 was the latest challenge for CLS, as for the rest of the global FX market, and as Bayle de Jessé explains, “The emergence of Covid-19 resulted in extreme market volatility and increased levels of FX trading. This reinforced the importance of resilient financial market infrastructures during times of crisis and the need to mitigate FX settlement risk. Despite record-breaking levels of activity, CLS settled on time and with no issues or delays. Furthermore, we expect additional volatility at the end of the year with the results of the US election and Brexit, which is likely to lead to increased FX trading activity.”
Although CLS is settling ever-increasing volumes of FX trades, Bayle de Jessé is very aware that the proportion of trades in the global FX market settling without PvP protection is increasing, leading to an overall increase in settlement risk. The ‘Bank for International Settlements (BIS) Triennial Central Bank Survey’ released in December 2019 highlighted that the proportion of trades settled with PvP protection has decreased from 50% in 2013 to 40% in 2019. More recently, in recognition of the importance of PvP settlement, a plan published by the Financial Stability Board, ‘Enhancing Cross-border Payments: Stage 3 roadmap’, highlighted the need to facilitate increased adoption of PvP settlement in order to enhance cross-border payments.
Bayle de Jessé suggests some of the reasons behind the rise in settlement risk, “The decline in PvP protection is explained by two factors. The first is the fact that a significant percentage of trades in CLS-eligible currencies are settling without PvP protection, and the second is the growth in trading of currencies not currently eligible for settlement in CLS, which are largely settled without PvP protection.”
CLS believes that now is the time to address increasing FX settlement risk and is working closely with key regulatory stakeholders and market participants to promote awareness of the rise in FX settlement risk and to support further PvP adoption.
| “Our continued focus is to mitigate FX settlement risk which involves encouraging broader participation in CLSSettlement across the global FX market. To do this we will continue to work with regulators, FX committees and market participants to better understand and raise awareness of the issue and look at ways to address it.” |
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CLS’s strategy has three short-term objectives: 1) educate key stakeholders about growing FX settlement risk; 2) strengthen the FX Global Code; and 3) advocate for better, high-quality data collection via the semi-annual turnover surveys of regional Foreign Exchange Committees (FXCs).
“We are encouraged by the engagement we have had with the market so far,” says Bayle de Jessé. “We have made real progress in creating awareness, making sure that the whole ecosystem understands the situation and is ready to explore what can be done to address it.”
“We are also encouraged by the Global Foreign Exchange’s (GFXC) leadership in efforts to enhance the FX Global Code. We believe that Principles 35 and 50, which relate to settlement risk, should be strengthened to better promote the use of PvP settlement mechanisms. The GFXC stated it would engage its member FXCs to consider ways to leverage the semi-annual turnover surveys to obtain a better understanding of trends in settlement activity. Any new solution that mitigates FX settlement risk will greatly benefit from efforts to obtain an improved picture of current FX settlement practices.”
Leveraging the BIS Triennial Surveys, CLS has also conducted its own analysis and concluded that the total volume of CLS-eligible currencies equates to USD5.34 trillion. CLS settles 31 percent of eligible FX transactions in those currencies. This means that 69 percent of transactions in CLS-eligible currencies are not settling in CLS.
CLS’s ability to address risks brought about by those trades not settling in CLS, such as adding new currencies to CLSSettlement, is limited because few remaining currencies can meet CLS’s currency onboarding standards which (as a systemically important financial market infrastructure) derive from the Principles for Financial Market Infrastructures (PFMI), other applicable regulations and CLS’s own standards. PFMI Principle 1, legal basis, and Principle 8, settlement finality, have presented the largest obstacles to onboarding new currencies to CLS’s settlement system. In 2019, CLS and Banco Central de Chile announced efforts to onboard the Chilean peso to CLSSettlement. “We are working with Banco Central de Chile, but it is an extended effort and involves encouraging broader direct participation in CLS from both local banks and CLS members across the global FX market,” says Bayle de Jessé.
An alternative PvP solution for non-CLS currencies
One approach could be for CLS to offer “alternative solutions” that would provide PvP protection. CLS is consulting market participants about any currency pairs particularly exposed to settlement risk. While an alternative PvP solution will take time to develop, Bayle de Jessé is optimistic that with the help of new processes and technology, CLS will be able to deliver PvP in currencies and currency pairs it does not currently cover. Meanwhile, CLSNet provides a bilateral netting calculation service that six of the top ten global banks are already using to enhance post-trade processes. “CLSNet aims to increase the levels of payment netting calculations for trades not settling in CLSSettlement by introducing standardization and automation for the entire FX market,” says Bayle de Jessé. “It does this by calculating the bilateral positions of the participants connected to the service.
“The service enables improvements to intraday liquidity, greater operational efficiency and increased risk mitigation for non-CLS-settled currencies, many of which are in emerging markets and are growing faster than those in current CLS jurisdictions. CLSNet may be a starting point for a solution that includes PvP settlement. Should CLSNet serve as the initial building block, there could be a series of tailored PvP settlement systems with groups of two or three countries with strong currency and economic ties.”
In summary
Bayle de Jessé concedes that although settlement risk is increasing and CLS is keen to do what it can to address this, the process will take time. “Our community of third-party participants is now well over 25,000, which demonstrates how FX market participants are becoming increasingly aware of the need to mitigate settlement risk.”
Third-party growth is a priority for CLS and it has seen nearly 6% growth in third-party settled values in the last year. He concludes, “We have been raising awareness of FX settlement risk among the wider FX community – asset managers, regional banks and corporates – ensuring these participants are aware of the exposures they currently face and how CLS could help to mitigate that risk.”
“Our continued focus is to mitigate settlement risk which involves encouraging broader participation in CLSSettlement across the global FX market. To do this we will continue to work with regulators, FXCs and market participants to better understand and raise awareness of the issue and look at ways to address it.”