What are the necessary ingredients for any PvP arrangement to work?
Marc Bayle de Jessé shares his views on the key features for any PvP service to deliver tangible and broad-based business benefits to end users in a safe and reliable way, ensuring that the systemic risk mitigation and other benefits of PvP are not compromised.
2022 marks CLS’s 20th anniversary, and this milestone has led us to reflect on the reasons for its success over the years. We believe, and conversations with CLS’s key stakeholders confirm, that it is the public-private partnership approach which garners CLS widespread industry support while also ensuring it is aligned to relevant policy and regulation, legal frameworks and the consideration of local market practices.
The organization has experienced considerable growth, in both values and volumes settled. In the last three years, the average daily value of transactions settled through CLSSettlement has grown by 11% percent, and in H1 2022 on average over USD6.5 trillion was settled every day. In July the service processed a single day record of 3.2 million payment instructions. Further, recent growth also includes increased uptake across the buy-side community, with a 25% increase in the number of third parties using CLSSettlement and 10% growth in third-party settled values in 2021.
Settlement risk mitigation
So what are the reasons for CLS’s growth? Above all, it has a proven track record in settlement risk mitigation: settlement members and their clients are protected from settlement risk, the most significant risk in the FX market. Crucially, CLS is able to settle transactions simultaneously – using its unique payment-versus-payment (PvP) system enabled by CLS maintaining accounts with all 18 central banks of the currencies settled – via access to the relevant real-time gross settlement (RTGS) systems. Further, settlement of the payment instructions and the associated payments is final and irrevocable. Finality is one of the most important elements of CLSSettlement.
“...settlement members often report that the funding and liquidity efficiencies are what make CLS so crucial to their FX operations, including their front offices.”
Multilateral netting facility to enable funding efficiencies
While CLS was established to address settlement risk mitigation, settlement members often report that the funding and liquidity efficiencies are what make CLS so crucial to their FX operations, including their front offices. Each day before settlement, CLS calculates the net funding required of each settlement member on a multilaterally netted basis. 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 process reduces the cash required to settle the payment of trades in a given day considerably, and frees up cash to support other business operations. In addition, CLS offers a liquidity management tool to settlement members – in/out swaps.
This service, combined with multilateral netting, results in an average funding requirement of less than 1% of the total value of all trades for participating settlement members. This efficiency is only possible due to the unique size, depth and global nature of the CLS network.
Large community of users
Last year, CLS settlement members participated in a working group to design and pilot an alternative PvP settlement mechanism for a broader spectrum of currencies. As part of this group, CLS settlement members cited ‘a large community of users’ as a key pre-requisite for any new PvP arrangement. Uniquely, CLS has the support of over 70 of the world’s most important financial institutions, which directly participate in CLSSettlement as settlement members. Over 30,000 third-party participants around the world also access its services indirectly through settlement members. These include banks, funds, non-bank financial institutions and multinational corporations.
Proven track record and operational resilience
Any entity providing PvP settlement should be regulated to ensure the appropriate level of oversight, governance and control, particularly when it comes to operational resilience and availability of the service. It is essential for such services to be resilient and scalable, using flexible technology. To address public policy and industry challenges (i.e., expanding access to settlement risk mitigation and providing the requisite levels of operational resilience) CLS has invested heavily in its products, risk management and controls and underlying technology. Of note, it successfully completed a significant phase of a multi-year technology investment program called Convergence. The next phase is to upgrade hardware and data centers.
“...CLS settlement members cited ‘a large community of users’ as a key pre-requisite for any new PvP arrangement. ”
Given that CLSSettlement has the necessary ingredients for a successful PvP settlement solution, the question often asked is: why can’t this model be extended to other currencies, including those in emerging markets?
As a systemically important financial market infrastructure (FMI), CLS is subject to the Principles for Financial Market Infrastructures (PFMI) published in 2012 by the Committee on Payments and Market Infrastructures and the Technical Committee of the International Organization of Securities Commissions. The PFMI standards are designed to ensure that the infrastructure supporting global financial markets is robust and able to withstand financial shocks.
“As a trusted FMI, CLS already has the requisite technology, oversight, governance, credibility and support of its members. ”
As a result, adding new currencies to CLSSettlement is an extended effort that is subject to several complex factors. In particular, it is necessary to ensure that crucial legal, risk and liquidity standards are met in the jurisdiction whose currency is onboarded. The pace of onboarding is not set by CLS but is primarily driven by local authorities and the preparedness of local market participants. The process also involves encouraging broader, active participation in CLSSettlement from both local banks and CLS settlement members across the global FX market, which takes time.
In the nearer term, to respond to policymakers’ and market participants’ calls for greater PvP adoption related to emerging market currencies, CLS has actively engaged the industry to explore alternative PvP mechanisms.
These efforts have received strong industry support, but recent geopolitical events have led CLS to reassess the pace at which this moves forward. This highlights one of the most significant points about expanding PvP coverage: progress in this area does not necessarily result from strong industry cooperation and technology advancements. As a trusted FMI, CLS already has the requisite technology, oversight, governance, credibility and support of its members. Instead, progress will be made by overcoming regulatory and geopolitical challenges, which currently pose the biggest obstacles to expanding PvP coverage.
To create ongoing demand, any PvP service needs to deliver tangible and broad-based business benefits to end users such as real liquidity and funding benefits; otherwise, demand for such a service may dwindle. But above all, to deliver the benefits of PvP safely and reliably, any provider needs to comply with a stringent list of requirements to guarantee the requisite levels of reliability and availability of service – otherwise, systemic risk mitigation and other benefits of PvP will be compromised