CLS for corporates – new challenges and opportunities
By Jonathan Butterfield, Executive Vice President, Marketing and Communication
CLS Bank International
The rise of FX
In recent years, foreign exchange (FX) has enjoyed a rise to prominence, evidenced by volumes that currently stand at an all time high. FX markets are in the midst of a profound change and momentum is building among traditional and non-traditional participants. Increasingly, FX is viewed as an investment tool presenting significant opportunities for improved alpha amongst an increasingly wide audience. FX trading related to cross border investment has increased, driven by the search for higher returns. Growth in volumes and numbers of participants has been helped by multiple trading platforms offering more competitive pricing and lower transaction costs.
FX has achieved the status of an asset class in its own right, attracting investors looking for a non-correlated asset class and clearly the carry-trade has generated significant trading volumes also. As well as growing, the market dynamics of the FX market are changing rapidly. Trading patterns are dividing between those participants who want physical delivery of their purchased currency, and those that simply want to exchange the net economic effect of all trades undertaken with each major counterparty. The increasing sophistication and use of electronic trading platforms has accelerated and both single and multi-bank platforms are gaining increased acceptance in the corporate market.
As market players continue to drive the growth in and velocity of FX trading, so has their awareness of exposure to settlement and operational risk increased. It is CLS Bank – the only global settlement system for eliminating FX settlement risk – that has uniquely underpinned the FX trading boom over the last five years, providing scalability for the market by reducing risk, providing enhanced operational and funding efficiency.
CLS and corporates
The banking industry agreed to adopt a disciplined global settlement standard five years ago. Having done so, these firms have now optimised all these and related processes to support further business growth. This is a major industry achievement and one appreciated by regulators as they continue to challenge the industry to eliminate settlement risk. Though the volume and values transacted by financial entities is growing most rapidly there is growth in corporate trading values as globalisation and economic growth continue. Another key consideration for corporates that participate in the FX market is the limitation of exposure to any one counterparty. Temporal settlement risk – the risk that one party defaults on a transaction after the other has already paid its obligation - can be viewed as the equivalent of a loan by the corporate to its counterparties. As participation on the FX market grows this exposure also grows, and corporates need to consider how they deal with this risk. Though settlement risk may be perceived as “a bank issue” many corporate treasurers comment to us that counterparty limit management is important to them too.
The recent Committee of Payment and Settlement Systems (CPSS) report, published by the Bank of International Settlements (BIS) in May and the first of its kind since the inception of CLS, highlighted the contribution CLS has made to the elimination of settlement risk and highlighted that 55 per cent of all FX transactions of those surveyed now settle through CLS. The respondents also confirmed that they planned to increase their use of CLS. Seventeen currencies are settled through CLS, accounting for 95% of the world’s FX trading value. Client trading and related settlement risk is on the regulator’s mind.
CLS has gone from settling an average daily volume of 45,000 instructions in 2002, to settling over 1,100,000 on its most recent record volume day in July this year. The average daily volume for the month of June 2008 stands at over 530,000 with an average value of $4.5 trillion a day, reflecting the recent volatility in the market which pushed FX volumes up significantly. Over the last five years, CLS has settled over 300 million sides with a value of $3 quadrillion, equal to over 50 times the world’s GDP. Daily CLS settles a greater value than any other cash settlement system in the world.
CLS participation can offer corporates a wide range of benefits that assist them in their use of the FX market and the wider management of their financial obligations. Corporates trading in the FX market today and settling in CLS indicate to us that they want to reduce risk, maximise operational efficiencies and comply with an increasing number of regulatory requirements such as Sarbanes-Oxley. Consequently, corporate treasurers need to ensure they have the solutions in place to meet these demands. Settling FX transactions through CLS Bank can help corporates address these issues, while at the same time reduce the number of bank settlements and reconciliations.
Corporates enter the FX market for broadly two reasons:
1) To fund obligations arising from business transactions; and
2) To facilitate hedging of existing financial positions.
Key to this is a high degree of accuracy in the management of cash flow. Many corporates already have integrated financial systems that are able to aggregate financial obligations to provide accurate cash forecasts that in turn feed the required FX values needed to support the business. Before CLS, this global view of cash positions was not totally transparent when it came to FX. CLS enables participants to access a global view of their FX positions in real time, providing a certain forecast for their FX funding requirements. Where previously funding arrangements had to be organised up to 24 hours in advance, CLS enables same day funding, with the consequential cost savings on interest and associated liquidity overheads.
This same day funding of the CLS cash settlement cycle minimises the time funds are tied up to prepare for and complete settlement. Furthermore, settlement in CLS occurs on a gross, individual payment versus payment (PvP) basis, but funding required for settlement is calculated on a multilateral netted basis. This can reduce the cash values required to settle but certainly reduces the number of payments that must be made to CLS. This netting effect can also be beneficial in reducing the size of intra-day credit lines required. Totally accurate cash forecasting, minimising the number of payments needed to settle a day’s trades and reducing trading errors and manual processing, allows participants are able to improve their cash management and trade reconciliation cycle.
By providing a real time settlement process with legal finality, CLS Bank protects participants against loss of principal associated with FX trades. In the event of a settlement failure, neither of the two payments for an FX trade will be settled and the related funding is immediately returned to the CLS Settlement Member. With the elimination of settlement risk and shorter, more secure settlement periods, corporate treasurers can significantly improve their operational control and oversight of their FX settlements as well as consider new FX counterparties.
Corporates that participate in the unique legal and operational framework provided by CLS are complying with the FX industry’s best practices. Operational oversight and control throughout the transaction life cycle can help organisations meet compliance with Sarbanes-Oxley and equivalent legislation. It is this adherence to best practice that is one of the most compelling reasons for settling FX via CLS.
CLS can deliver cost savings through operational efficiencies, some of the benefits include enhanced straight-through-processing (STP), reduced number of settlements and associated transaction costs, reduced errors with virtually no instances of settlement failure, and more efficient allocation of monetary and physical resources.
CLS-enabled banks will send corporate participants a report of trades whose instructions have or have not matched in CLS. This match is normally well within one hour of the trade being executed. Any issues arising can be actively managed in advance of settlement rather than the cumbersome process of resolving issues following a settlement failure. Pre-settlement matching eliminates failed settlements and consequently, any resulting interest and compensation claims.
New opportunities
Aside from the traditional spot FX, non-deliverable forwards (NDFs) are increasingly being used by corporates as a vehicle for hedging in non-convertible currencies. Under the terms of an NDF, two parties agree to “net cash settle” a forward FX transaction. The profit or loss is calculated by taking the difference between (i) the agreed upon exchange rate and (ii) the prevailing spot rate on the NDF valuation date, for an agreed upon notional amount of funds. On the NDF settlement date, the party with the “loss” makes a payment of this difference to the other party.
CLS has now extended its service to process and settle NDFs. This allows automation in an environment where little automation exists, delivering more convergence and standardisation, bringing increased efficiency and resulting in significant cost reduction. NDFs have traditionally been associated with manual processes, long-form confirmations, and lack of standardisation. These factors contribute to expensive processing costs for NDFs, estimated at $19.70 per trade, a multiple of the cost to process an FX trade.
CLS brings improved STP to NDF processing in 48 currencies, with reduced number of payments also providing for enhanced liquidity benefits as already seen in the spot and forward FX market.
Overall CLS participation can bring real benefits to corporates in terms of risk, time value of cash assets, and straight through processing, both in terms of accuracy in information and process, and reliability. To quote Ulrich Kammholz, Director, Global Foreign Exchange Risk Management, NIKE Inc: “With no increase in day-to-day system costs we have freed up to 70% of the resources that used to be tied up dealing with FX settlement. Elimination of settlement risk and a much higher level of control are important benefits, but it is the improvements in operating efficiency and the level of automation that are providing the big gains for us.”