CLS: The Missing Link in Foreign Exchange Settlements 

By Michael DuCharme, Russell Investment Group ¹

Foreign exchange (FX) markets are in the midst of profound change, yet many investment managers who trade currencies are unaware of it. The Continuous Linked Settlement (CLS) service offered by CLS Bank International (CLS Bank) provides a process to manage settlement risk ² for FX market participants, including investment managers. Those who are unaware of CLS may be experiencing unnecessary and excessive operational costs as well as suffering higher transaction costs.

CLS Bank was launched in 2002 by the world’s largest banks and financial institutions to create the only global settlement system for managing settlement risk. CLS allows members and their clients to settle payment instructions related to foreign exchange deals in real time, eliminating the time zone differences that can cause payment delays and give rise to settlement risk. Fifteen currencies are eligible for CLS settlement, including all the major currencies and several emerging market currencies.

Settlement Risk and Transaction Costs

CLS radically changes how FX deals are settled, giving investment managers the opportunity to significantly reduce settlement risk, while lowering transaction costs. The Society for Worldwide Interbank Financial Telecommunication (SWIFT) provides an industry standard message type (MT304) making it easy for investment managers to participate in CLS. Importantly, CLS offers significant benefits to investment managers besides the reduction of settlement risk. Even though CLS is still evolving and some aspects of the process limit its effectiveness, CLS gives managers the power to manage settlements, reduce costs, and enhance operational processing.

With a stronger global economy, investment managers increasingly are turning to the international marketplace for higher returns. This requires them to exchange currencies as part of related security trading. In addition, increasing numbers of investment managers view currency as an asset class with significant opportunities for improved alpha. Others are uncomfortable with the exposure to currency risk in their portfolios and use forward contracts to hedge that risk.

Unfortunately, while investment managers have shown an increased interest in the FX markets, they haven’t shown as much interest in managing transaction costs. A big reason for excessive transaction costs involves trading practices. Many investment managers trade with only one counterparty, often the custodian of their accounts. This trading practice is simple and low risk. It avoids settlement risk because only one party, the custodian, is involved in the transaction. Yet the benefits of simplicity and low risk come at a high cost because trading with a single counterparty inhibits competition. Investment managers who desire competitive pricing do business with multiple trading partners using electronic communication networks.

The downside to using a wider array of trading partners (third parties) and venues is increased exposure to settlement risk. In third-party transactions, investment managers arrange the FX deal between their client (represented by the client’s custodian) and a bank counterparty. Although the custodian and the bank are principals to the deal, they don’t trade directly with one another. Instead, the investment manager negotiates the FX transaction, acting as a middle man. Because the parties have a common relationship with the investment manager who arranged the transaction, they tend to drag the investment manager into disputes when settlements fail.

Settlement failure can occur for a variety of reasons, including counterparty collapse, incorrect settlement instructions, and human error. Collapse of a counterparty is a rare event, although the failure of Herstatt Bank in 1974 is evidence of that catastrophic risk (Herstatt Bank had received its foreign currency payments but collapsed before making its US dollar payments, causing many counterparties to suffer significant losses). While most settlements are completed successfully, the initial settlement date is sometimes missed, resulting in overdraft charges and claims.

Investment managers typically are unaware of settlement issues until the day after settlement when the custodian or the bank alerts the investment manager to the failed deal. Now that the deal is already one day late, the investment manager is necessarily reactive in resolving the problem. First, the investment manager has to decide where the problem lies: did the investment manager make a mistake (forwarding outdated settlement instructions to one of the parties could be one example), or is the bank or custodian at fault? Once the investment manager has devised a solution, the manager must implement and monitor the solution. If overdraft charges have resulted, the party at fault sometimes is reluctant to pay them. Weeks and even months can go by between communications with the parties involved, all while the claimant is calling the investment manager, asking why there isn’t a response. The frustrated investment manager can only call or email once more.

CLS addresses this frustration by allowing investment managers to proactively manage settlement risk. On the day of trading or the next day, the investment manager receives a report from the custodian of the client’s account, showing which deals aren’t matched and ready for settlement. Since most investment manager deals are related to security transactions or hedging, they’re 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 the investment manager time to call the bank and resolve the issue.

How Does CLS Work?

CLS provides a continuous mechanism for the simultaneous settlement of both sides of an FX deal. The mechanism involves an ongoing process of submitting trade instructions, matching those trades, funding the deals, and then paying out to the participating accounts. CLS operates as a Payment versus Payment (PvP) system, which differs from the more traditional Delivery versus Payment (DvP) process. The two sides to a foreign exchange transaction are settled separately in a DvP transaction. Time zone differences increase the risk of one party defaulting before both sides of the trade are settled. PvP eliminates time zone risk because CLS settles both sides of a transaction simultaneously. Settlement in CLS is final and irrevocable.

Investment managers can participate easily in CLS if the account custodian and the bank trading partner are eligible to settle via CLS and if their currency deal involves the settlement of these 17 currencies ³:

The investment manager sends an electronic message containing the details of the trade to his or her custodian. The custodian then sends a similar message to CLS where it matches with the trade from the bank trading partner. If all instructions meet criteria established by CLS, the currencies will be exchanged on the settlement date. Otherwise, the funds are returned to the participants, thus eliminating settlement risk.

Other Benefits of CLS

Besides giving investment managers the ability to manage settlement risk, CLS provides other benefits. For example, CLS improves operational efficiency by enhancing straight-through processing, providing real-time reporting, and allocating staff and other resources effectively.

For many investment managers, CLS is the missing link in the life cycle of trading and settling. CLS gives managers operational oversight of the settlement part of FX deals. Importantly, investment managers generally can demonstrate to auditors and risk managers a sharply reduced exposure to settlement risk which should decrease the investment manager’s potential liability to claims and other settlement charges.

CLS enhances compliance with best execution practices. Because CLS can significantly reduce settlement failures, investment managers can trade with banks other than the account custodian with a high level of assurance that the deal will settle on time. Investment managers can use the results of competitive pricing to demonstrate, in part, that they are meeting their best execution objectives.

CLS can also provide business opportunities. Pension clients are becoming more interested in showing their beneficiaries that they’re providing better value at lower cost. CLS helps achieve this by increasing the likelihood of settlement with less intervention in the settlement process. Thus, because only a few investment managers currently participate in CLS, those who use CLS can distinguish themselves from their competitors by demonstrating they can provide lower transaction costs with reduced risk of settlement failure.

Drawbacks to CLS

CLS enhances best practice in foreign exchange trading but drawbacks exist. For example, most FX deals involve the 17 currencies that are CLS eligible, but increasingly popular currencies like the Turkish lira and Polish zloty aren’t included.

Only a few custodians currently participate in the CLS process, significantly limiting its effectiveness. However, because of the many benefits, it is likely that more custodians soon will be joining CLS. A larger number of custodians will likely make CLS more available to investment managers, giving them better opportunity to manage settlement risk and reduce transaction costs.

Another shortcoming is that CLS doesn’t have a central reporting system for investment managers. Instead, investment managers depend on the account custodian for reports about failing trades. Thus, an investment manager can receive multiple reports from many custodians each day, making management of the process somewhat inefficient. A central reporting system that consolidates trade information from all custodians would benefit the investment manager community.

Nearly Free is a Very Good Price

CLS charges the bank counterparty and custodian a low fee to settle deals in CLS. As a result, investment managers have a unique opportunity to reduce risk, streamline operations, lower transaction costs, and show clients how they’re complying with best execution with little or no out-of-pocket costs.

The move to CLS has the potential to be an industry-changing event. Investment managers not yet on the CLS bandwagon will want to take a good look at this opportunity to provide better client service with lower costs and lower risk.

Michael DuCharme is manager of currency business operations for the Tacoma, Washington-based Russell Investment Group, where he identifies, implements and manages new technologies and infrastructure to streamline foreign exchange operations and reduce operational risk. He is a CFA Charterholder.

¹ The views expressed in this article are those of the author and not of the Russell Investment Group and do not constitute an endorsement of Continuous Linked Settlement or CLS Bank International.

² Settlement risk is the risk of loss when a party pays the currency it sold but doesn’t receive the currency it bought.

³ Effective May 2008