Banks go live on CLS

Continuous Linked Settlement (CLS) - the long-awaited industry initiative to cut settlement risk for foreign exchange - will go live today.

Following the go-ahead from the Federal Reserve last Thursday, 39 of the CLS Bank International’s 66 shareholders are now free to use the system to settle trades in seven eligible currencies.

Including all the largest banks in the FX industry, this represents "a big chunk of the market", according to Joseph De Feo, president and chief executive of CLS Bank International in New York. The full 66 represent "maybe 80% of the total value of global turnover in those currencies", De Feo added.

"This is a very positive development for the industry," said David Puth, global head of FX at JP Morgan Chase in New York. "It will have a very positive impact on the way we look at credit and settlement risk."

At launch, CLS will settle trades in US dollar, euro, yen, sterling, Swiss franc, Canadian and Australian dollars. Settlement in four additional currencies - the Swedish krona, Danish kroner, Norwegian krone and Singapore dollar will be added in 2003.

As these currencies arguably represent potentially higher settlement risk, CLS settlement in them may prove to be of even more value to users, De Feo said.

Although the elimination of settlement risk in FX - the risk that one party could default on payment after its counterparty has released its funds - has been the prime motivator behind the CLS initiative, De Feo said it offers other benefits to users.

"You can’t unwind a CLS transaction," he told RiskNews' sister publication FX Week. "We have created a consistent legal framework for all seven currencies and all participating countries. That brings value to our shareholders because they know they don’t have any legal risk."

Cost savings are another key benefit, he said. "Our facility is going to reduce the overheads of the business." One estimate is that the system could reduce the gross number of payments made by 96% compared with the current correspondent banking system of settlement, he said. A reduction of that size in payments would have additional benefits because fewer payments means fewer keying errors, De Feo added.

CLS is now looking at adding settlement in cross-border securities for money markets and derivatives, and has also discussed with the multi-bank FX portals the possibility of linking up systems to increase straight-through processing of trades. "If they can eliminate costs, our shareholders are going to pursue it," said De Feo of the potential link to FX portals.

De Feo said the final launch of CLS after years of delays had been an "incredible achievement". Initially scheduled for launch in January 1999, the system has missed at least three subsequent published deadlines - which CLS attributed to delays with the core technology developed by IBM. But, said De Feo, the biggest obstacle proved to be keeping the project together. "We had problems with the technical issues that have been overcome, and IBM deserves to share in the success. The most difficult thing has been keeping the coalition together," De Feo said, citing the number of regulatory bodies, and different languages and cultures involved in the project.

Efforts to solve the settlement risk issue have been made by the industry since the collapse of German private bank Bankhaus Herstatt in 1974, which set off a chain of defaulted settlement payments. A group of banks calling themselves the G20 got together in March 1996 to resolve the issue, which led to the formation of CLS in July 1997. IBM was selected as the technology developer in May 1998.

The system enables banks to settle their FX transactions through New York-based CLS Bank International, in a real-time five-hour window. FX payments will be considered and matched in pairs, with book entries for both sides of a transaction debited or credited simultaneously.

De Feo expects to attract more shareholders to the enterprise, citing the potential for 100-150 global banks to be involved. More may want to join if the initiative is extended to money markets and derivatives, he said. Shareholders have all contributed about $5 million apiece to the project, and to fulfil the requirements to become settlement members - the group, now of 39, entitled to settle trades directly via the system - they will have spent about that much again, said one bank official.

Notwithstanding the cost, De Feo said a further 12 more shareholders will become settlement members before the end of the year, taking that total to 51. Shareholders who are not settlement members are currently represented on the company’s various committees, and have voting rights on the board, but are only able to use the service via one of the settlement members’ third-party CLS services. This has prompted a large rush among settlement members to sign up their fellow banks as clients.