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Cash securities and derivative markets have developed in both sophistication and efficiency, particularly over the course of the last 10 years. The changes we have seen have been driven by a variety of factors ranging from ever increasing business volumes, the need to manage risk, and legal and regulatory requirements. As a result it is fair to say that trading clearing and settlement in securities markets, particularly in many domestic markets though to a lesser extent cross-border, is becoming increasingly cost effective and efficient. Furthermore the mitigation of risk, for example operational, credit and market risk, has steadily improved. All of these factors have contributed to an environment of increasing trust across the functions of the trading value chain. A programme of steady improvement continues, with the major debate currently surrounding the barriers to efficient cross-border trading, particularly in respect of clearing and settlement.
Foreign exchange (FX) trading represents average daily turnover of more than USD1.3tr, and yet these markets remain relatively unstructured, have not been subject to the same levels of regulation and do not enjoy the benefits of centralised clearing and settlement. In this short article we will consider some of the recent changes in FX trading and those scheduled for launch during 2002. The most significant of these is likely to be the launch of Continuous Linked Settlement Bank. In addition there have been changes to the facilities focused on front office activities, including the trading platforms launched during the last few months.
FX trading
To state the obvious, foreign exchange trading is about exchanging cash in one currency for cash in another. The cash involved in FX transactions is by its very nature a homogenous, fungible commodity traded on a cross-border basis. As such it would appear to be an ideal instrument around which to build exchange-based trading, a model for cross-border securities trading.
There are of course trading platforms, some of which have been around for many years such as Reuters Dealing 3000 (originally 2000) and EBS, both of which have been enormously successful in the inter-bank wholesale market. More recently numerous new services have been launched such as Currenex, FXConnect, FXall and Atriax. These trading platforms are effectively exchanges as they exhibit many of the properties associated with an exchange. For example they:
- are neutral to the trading process and provide both price and general market information to members;
- support trading in a range of instruments for example spot, forward and swap FX;
- have restrictions on who is able to participate in the market, thus offering a safe environment (from the counter party credit point of view) in which trading can take place;
- are supported by banks providing liquidity.
The newer trading platforms are open to a wider community than just banks as they seek to offer market access to professional FX traders including corporate treasurers, money managers and hedge funds. It remains to be seen which will be successful. Two years ago, for example, there were a number of ECNs launched aimed at the bond trading community (both the market professionals and buy-side) and many of these have not survived. They found that there was both insufficient business volume and liquidity, or that it was not possible to differentiate themselves from the competition. Indeed, those that have been successful appear to be the ones that are backed by the major banks to provide both order flow and liquidity. they have also sought to differentiate themselves by offering a broader range of services and penetration of different market sectors, for example offering derivative products as well as cash and admitting market takers (that is, the customers of the investment banks who act as market makers).
There are parallels amongst the FX trading platforms as they offer market participants a variety of services. Many of the platforms are backed by the leading FX trading banks, offering multi-dealer quotes on a variety of instruments from spot FX to currency swaps. This is likely to be a key factor in the battle for survival as the patronage of the banks will not only ensure that there is a liquid market but also provide the order flow necessary to make the trading platform commercially viable. In an environment where bid-offer spreads are already extremely tight and with a business model based on transaction fee alone, the ability to capture a significant portion of the market will be vital. The economics inevitably mean that there will be consolidation as not all platforms will be able to generate the revenue necessary to cover costs. That said, FX trading is a major source of revenue for banks; consequently a platform with major banks as shareholders may have less requirement to be profitable. Simply providing a route to market could be sufficient.
The range of services offered by the leading players includes research, portfolio trading and technological solutions designed to facilitate access either over the Internet or a virtual private network as well as straight-through processing (STP). The objective is to offer a package of products, easy access to the market with the additional value add of STP which reduces errors, manual data entry and improves efficiency, and offers the added value of STP. It remains to be seen however whether or not electronic FX trading will replace the relationship between broker and customer. It will not be easy to replace a service which is based around integrated banking with one which is specialised around FX. It is also worth remembering that the computer does not buy you lunch.
The CLS proposition
It will not only be front-end FX trading that is impacted by changes during the course of 2002. After a long wait the launch of Continuous Linked Settlement Bank (CLS) is expected during the second or third quarter of the year. Over time its implementation is going to have a significant impact on most institutions active in the FX markets.
The origins of CLS date back to 1974 and the collapse of Bank Herstatt, which demonstrated the stark reality of settlement risk in the FX markets. In summary, funds were paid away by US banks settling one leg of a transaction, but nothing was paid back as the German regulators had shut down Bank Herstatt. This sequence of events resulted in significant liquidity problems. Many years then passed and there were more bank failures including Drexel Burnham Lambert, BCCI and Barings until in 1997, in response to regulatory pressure, the concept of CLS was born.
As noted above, the global FX market is worth on average in excess of USD1.3tr a day and the largest institutions have billions of dollars at risk each day. The exposure of any institution, even a large bank, to a single trading counter party can be well in excess of its capital. To address this and to reduce the scale of settlement risk in the FX markets, leading institutions and regulators concluded that a Payment versus Payment (PvP) system needed to be developed, similar to the Delivery versus Payment (DvP) systems that have evolved in the securities clearing and settlement industry. CLS Services Ltd was accordingly formed in 1997 to create this PvP system to eliminate settlement risk by simultaneously exchanging currencies with legal finality for every eligible FX transaction submitted to CLS Bank. The following diagram illustrates how this will work in practice.
There are tiers of CLS membership. There are the Settlement Members who hold multi-currency accounts in CLS and can submit settlement instructions. They can also authorise the instructions submitted by a User Member, as User Members do not have CLS accounts but are sponsored by Settlement Members who act as principal on their behalf. A Settlement Member is required to make the payments necessary to settle each instruction through its account, whether for itself or for one or more User Members.
There is a further category of potential CLS user. 'Third parties' can use the CLS service by having members, as principals, submit instructions on their behalf. The terms on which members will act on behalf of third third parties are governed by private arrangement. These do not directly involve CLS Bank and third third parties do not have any relationship with CLS Bank.
The third party market
During the course of the last 12 months Pricewaterhouse-Coopers and Payment Research Partnership have been conducting a study into the impact that the CLS system will have on the global foreign exchange markets. The study focused particularly on the impact of CLS on those institutions that are not (or not yet) CLS Settlement Members, that is, the 'third party market'. The research was based on detailed questionnaires and then interviews with representatives from our study group of banks and corporate treasurers .
The comprehensive report resulting from our study was published in October 2001. It includes analyses of the impact of the CLS system on markets and market practices, and of liquidity, legal and other topics, and a detailed breakdown of the issues for consideration by potential and prospective third party users of CLS. Its analyses and conclusions are as relevant to those banks seeking to shape and position the services they plan to supply to the third party market as they are to the potential users -- bank and non-bank -- of those services. Although the detailed findings of the report will inevitably need to be refined when CLS has gone live, and as market practices and business models develop, the issues it identifies and the recommendations it sets out will remain valid for the foreseeable future.
Findings
The implementation of CLS represents one of the most important changes in recent years to the infrastructure of the global FX markets. It will, from its first day of live operation, have a substantial impact on the business practices of the CLS Settlement Members. It will also have an impact on other banks and institutions which are active in the FX markets; and they will feel that impact whether or not they choose to establish a third party (or fourth party) relationship with the CLS community. If they decide to settle their eligible trades through CLS Bank, with a view to reducing their settlement risk on those trades or merely in order to conform to market pressures, they will need to appoint a service provider, as well as one or more nostro agents, and will then have to make whatever consequential changes are required to their business practices. If on the other hand they choose not to settle any trades through CLS Bank, they will nonetheless find that the post-trade FX market as a whole is changing around them, in response -- at least in part -- to the stimulus of CLS. Moreover the pre-trade FX market will in due course begin to change for all those who are active in the market, whether or not they choose to settle their trades through CLS.
But despite that prospect, it is clear that many Settlement Members have not sought to prepare their customer base for the impact of CLS. This may be a result of the numerous delays suffered by the CLS project to date, causing many to adopt a wait and see approach. As a result it now seems that potential third parties do not really know or understand what is coming. While some of the reasons for this are understandable (including the delays in implementing the CLS service), it has left a lack of hard information, and even of basic understanding, prevalent in the market place. This will not contribute to a rapid and smooth take-up of the service.
Risk and liquidity issues
CLS is designed to mitigate the risk of settlement failure by providing a mechanism for ensuring payment versus payment in central bank money. This concept is generally well understood by the banks making up the Settlement Members. However others; outside this group, the corporate treasurers for example, do not share such a clear view of the benefits. There is a strong tendency to assume that settlement risk solely reflects counterparty credit exposures. A number of those interviewed during our survey were not concerned about how their bank chooses to settle with counter parties, arguing that it was up to the bank to manage credit exposures and that mitigation of settlement risk was not a service for which they would be prepared to pay. When you look at the limited exposure of a corporate in the FX market versus that of a bank, it is not hard to see why the former would not be concerned.
In similar vein, a leading credit rating agency argued that the main benefit of CLS would be in the increased efficiency to be derived from STP and that managing settlement risk, whilst important for organisations involved in the FX markets, was not a significant factor in an assessment of credit ratings. Consequently as a result the use -- or non-use -- of CLS to settle its trades would have no impact on the assessment of an organisation's credit rating.
Although the concepts and value proposition of CLS are well understood by those close to the project, these responses make it clear that the economic, and indeed the regulatory, justification for CLS -- the need to manage settlement risk, whatever its causes -- is not widely appreciated among many important FX-trading institutions. It is clear that there is a great deal of work still to be done in marketing and education for potential third party users of CLS, though the third party market will be largely made up of banks who are not CLS members, plus a limited group of corporates. Furthermore, for the Settlement Members looking to offer services to the third party market, getting the scope of those services and associated commercial propositions right will be critical. These include
The sources and the cost of intra-day liquidity for prospective third parties, which need to know whether the deadlines set by their nostro agents or their service providers will coincide with, or be more relaxed than, the deadlines set by CLS on its Settlement Members; and from where, and at what cost, they will be able to meet their liquidity needs. Although there is likely to be some competition on these questions among prospective service providers, a more uniform approach -- for instance on the operation of a market in intra-day liquidity in each of the CLS currencies -- is likely to emerge over time.
Decisions for third parties
As noted above, the main focus of the research for this study was the impact of CLS on the third party market; much effort therefore went into assessing their needs and the corresponding services that should be offered.
The implementation of CLS will require -- indeed it already requires -- a variety of decisions by all those institutions that are trading in the FX market for their own account or for account of their customers -- decisions by Settlement Members on the nature and the terms of the services they will provide, and decisions by other institutions as to whether, and if so how and through whom, they will settle their trades through CLS Bank. These decisions are likely to be more soundly based if they start from a clear understanding of the costs and the benefits of the CLS service, and of all the implications for each institution, whether it is a provider or a potential user of third party services.
The PricewaterhouseCoopers/Payment Research Partnership report therefore includes a decision matrix which is designed to assist every potential third party in determining its profile in respect of its FX trading activities. It provides a check-list of the different factors to be considered and the criteria to be applied when an institution decides to obtain CLS services from a Settlement Member and from a nostro agent; and it sets out a further check list to assist in preparing and planning the transition for a prospective third party into the CLS settlement environment. In total the report identifies over 100 issues that would affect the decision to participate in CLS, the type of services that would be most appropriate for a given user and factors to consider when selecting a service provider.
Conclusions
Whilst the future for and impact of the newly emerging FX trading platforms remains a subject for debate, CLS will have a significant impact on the financial markets. A combination of pressure from regulators and the level of investment to date will serve to ensure that it plays a central role in the future. That said, however, the true value of CLS to the various parties involved has not yet been fully articulated and recognised in all quarters. This is an issue that will no doubt be addressed once live operation commences.
The range of services offered by CLS will change as the organisation matures. The scope of the basic service will expand as the seven initial currencies are joined by four more, and others in the future. Furthermore, building the capability to handle cross-border clearing and settlement of securities transactions will introduce a raft of complexity and new challenges, though there are potential benefits from clearing and settling cross-border securities transactions closely coupled with the operations of the existing CSDs.
Whether CLS will eventually become the settlement engine for a wide range of financial market transactions with a view to achieving a very significant risk reduction in the value chain remains to be seen. What is certain is that all institutions actively engaged in the FX market must take the CLS scheme seriously; and to take it seriously they must understand it. We hope that this study will contribute to that task.
