Mitigating Risk and Enhancing Financial Stability in the Global FX

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Mitigating Risk and
Enhancing Financial Stability
in the Global FX Market
Reducing Risk
in the Global FX Market
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CLS plays a fundamental role in the FX market.
Mission Statement:
To enhance financial
stability by providing risk
mitigation services to the
global FX market.
Owned by the world’s leading financial institutions, it operates
the largest multicurrency cash settlement system to mitigate
settlement risk for the FX transactions of its Members and
their customers.
This is achieved through the provision of CLS’ unique payment-versus-payment (PvP)
settlement service which has links to the real time gross settlement (RTGS) systems
of the 17 currencies eligible for settlement in CLS.
The FX market is a key part of global economic activity. It is the largest financial market
by value and is integral to global commerce. The reasons for exchanging currencies are as
diverse as the community who trade them. All members of the FX community potentially bear
the risk of loss of principal due to settlement risk. Settlement risk is widely recognized as the
most significant systemic risk to participants in the FX market, making its mitigation a high
priority for the community as a whole. By effectively mitigating this risk for its Members
and their customers, CLS plays a critical role in ensuring the smooth running
of the FX market and providing stability to broader financial markets.
The importance of which is further underscored by CLS’
designation as a systemically important financial
market utility (FMU)1.
Front cover clock:
Greenwich Shepherd Gate Clock
United Kingdom, 1852
The first to display Greenwich Mean Time to the public.
Designated by the Financial Stability Oversight Council, the
financial regulator created as part of the Dodd-Frank Wall Street
Reform and Consumer Protection Act 2010.
1
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1
The Evolution of CLS
The impetus behind the creation of CLS came from regulatory
concerns regarding the potential for FX settlement risk to
be a major source of systemic risk. CLS was established as
a private sector initiative to deliver and operate a service to
mitigate settlement risk in the FX market.
In 2002, CLS was launched with seven currencies and 39 Members. Since then, the CLS
community has grown significantly and now includes 17 currencies, over 60 members and
thousands of third party participants.
CLS’ unique position within the FX industry enables it to work closely with market participants
to develop, adapt and extend its settlement services in response to evolving market
requirements. For example, the partnership with the Depository Trust and Clearing Corporation
(DTCC) for the OTC market and the introduction of the trade compression service, CLS
Aggregation, with Traiana.
As the infrastructure that supports the FX market, CLS continues to deliver the settlement
service, even during times of severe market stress. The economic uncertainty during the
financial crisis of 2008 proved a defining moment for CLS. Despite periods of extreme volatility
and deteriorating market sentiment, CLS delivered the settlement service without any failures
and the FX market continued to function without disruption.
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Settlement Risk (also known as Principal Risk)
Settlement of FX transactions requires the exchange of principal in two currencies.
Settlement or principal risk is the risk that one party to a FX transaction will deliver
the currency it sold, but not receive the bought currency from its counterparty, resulting
in the loss of principal.
It is also known as “Herstatt Risk”, a name derived from the failure of a privately owned
German bank – Bankhaus Herstatt. In June 1974, the bank’s license was withdrawn by
regulators which forced it into liquidation. Time zone differences meant that Bankhaus
Herstatt had ceased operations after receiving DEM payments but before it released its
USD payments, resulting in a significant loss of principal2.
2
More information can be found in BIS: “Bank Failures in Mature Economies”, BCBS Working Papers No. 13, April 2004.
Caesium Atomic Clock, National Physical Laboratory, United Kingdom, 1955
The first accurate atomic clock which led to the internationally agreed definition
of the second. This second has an accuracy of one second in 15 million years.
Since launch, CLS has settled
over USD 7,700 trillion
2 Mitigating Risk and Enhancing Financial Stability in the Global FX Market
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3
The Evolution of CLS
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September 2011
Record volume day:
September 2002
CLS launched – 39 Members
and seven currencies
(Australian Dollar, Canadian
Dollar, Euro, Japanese Yen,
Swiss Franc, UK Pound,
US Dollar)
March 1996
June 1974
Bankhaus Herstatt
fails
Committee on Payment
and Settlement Systems
(CPSS) publishes a report:
Settlement Risk In Foreign
Exchange Transactions
(the Allsopp Report) – a
strategy for addressing
FX settlement risk
1970s
February 2004
March 2008
First FX transaction settled for a fund
counterparty – investment management
community begin using CLS
1990s
2002
2003
2004
2005
2006
2007
Period of market
volatility, CLS settles
an average of over
one million payment
instructions per day with
an average daily value of
USD 4.2 trillion
2009
4 Mitigating Risk and Enhancing Financial Stability in the Global FX Market
ACI Model Code3 recommends
“Institutions active in FX trading
should be CLS participants
where possible.”
2011
May 2008
January 2010
Four more currencies
added – Danish Krone,
Norwegian Krone,
Singapore Dollar
and Swedish Krona
Settlement extended
for certain over-thecounter (OTC) credit
derivatives through
a partnership between
the DTCC and CLS
CPSS publishes a report on settlement
risk, which renews the focus on
settlement risk reduction, commends the
CLS PvP architecture and provides steps
to further mitigate settlement risk
CLS Aggregation launched to
address the capacity challenges
faced by banks resulting from the
growth in FX trading from hedge
funds, algorithmic traders, retail
and institutional clients
May 2008
Israeli Shekel and Mexican Peso added bringing the
total number of currencies settled by CLS up to 17
Cosmo Clock, Yokahama, Japan, 1989
A CI, The Model Code - The International Code of Conduct
and Practice for the Financial Markets, September 2012.
2010
September 2012
December 2007
For over 10 years, CLS has settled
FX transactions with finality
3
September 2012
September 2003
2000s
CLS designated
a systemically
important FMU
May 2010
in one day – a record
value for the
service
2008
July 2012
CLS celebrates its 10 year Anniversary
10.3 trillion
Four more currencies added –
Hong Kong Dollar, Korean Won,
New Zealand Dollar, South African Rand
2001
payment instructions
settled in one day
As conditions deteriorated
in the global capital markets
following the collapse of
Lehman Brothers, CLS delivered
the settlement service and the
FX market continued to function
without disruption
CLS settles USD
December 2004
2000
1,960,492
September 2008
Part clock, part giant ferris wheel.
The world’s largest clock.
2012
A Global Community
Critical Infrastructure
CLS settles payment instructions relating to FX trades
in 17 currencies, which account for 94%4 of the total
daily value of currencies traded globally.
CLS’ role as a critical infrastructure puts it at the center
of the FX industry.
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The CLS community involves a global network of central banks, commercial banks, investment
firms, corporates and fund managers.
CLS provides settlement services to participants both directly (for Settlement Members) and
indirectly (through Settlement Members providing third party access to their customers). CLS
works closely with technology vendors, business partners and regulators to ensure delivery
of robust and resilient settlement services.
Australian Dollar
Canadian Dollar
Danish Krone
Euro
Vendors
SWIFT
(provide connectivity
between Settlement
Members and CLS)
(network and
messaging
standards)
Oversight
Committee
of 22 central banks
Service Delivery
and Development
Partners
17 RTGS Systems
Hong Kong Dollar
Israeli Shekel
Japanese Yen
Korean Won
Mexican Peso
New Zealand Dollar
Norwegian Krone
Singapore Dollar
Nostros
South African Rand
Members
Liquidity Providers
Swedish Krona
Swiss Franc
UK Pound
US Dollar
Third Parties
CLS is connected to 17 RTGS systems
globally, between CET 07.00 and 10.00
4
BIS Triennial Central Bank Survey – FX and derivatives market activity in April 2010 (September 2010).
6 Mitigating Risk and Enhancing Financial Stability in the Global FX Market
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Benefits
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In addition to mitigating settlement risk, there are a number
of unique benefits for both direct (Settlement Members)
and indirect (third parties) participants that join CLS.
»» Mitigating global FX settlement risk
»» Efficient liquidity management
»» Efficient credit line management
»» Expanded range of counterparties
Huygen Pendulum Clock,
Netherlands, 1657
A breakthrough in timekeeping
through the discovery of the
center of oscillation and its
reciprocal relationship with the
pivot point of the pendulum.
»» Payment efficiencies through enhanced Straight Through Processing (STP)
»» Potential for new third party or nostro business
»» Transparent and standardized processes and confirmations
Benefits for Settlement Members
»» Liquidity efficiencies through the multilateral payment netting provided by CLS
– the amount of cash required by CLS to settle all payment instructions is reduced
by an average of 96% (before In/Out Swaps5)
»» Operational and IT efficiencies through standardization and enhanced STP
»» Participation in a unique financial market infrastructure at the center of the FX market
which creates opportunities for dialog across the community
»» Business growth and new revenue opportunities through increased trading capacity,
the opportunity to offer third party CLS services and FX Prime Brokerage to customers, and
the provision of nostro services
»» Higher standards – all Settlement Members enter into identical Agreements with CLS and
operate under a defined set of the Rules. Adoption of best practices, business continuity
processes and resiliency promotes higher standards
Benefits for Third Parties
»» Operational and IT efficiencies and cost savings through enhanced STP
»» Reduced errors
»» Reduced number of settlements
»» More efficient allocation of monetary and physical resources
Today, on average USD 14.5 billion
is paid each day into CLS between
CET 06.30 and 07.05
»» Improved liquidity management through the reduced number and amount
of payments resulting from multilateral payment netting
»» Business growth through increased trading capacity and credit availability
5
T he In/Out Swap Service is designed to reduce the payment obligations to CLS and to mitigate liquidity
pressures. An In/Out Swap is an intraday swap consisting of two equal and opposite FX transactions
that are agreed as an intraday swap. On average, In/Out Swaps reduce payment obligations in CLS by
75%, translating to a funding requirement in CLS of less than 1% of the total gross settlement value.
8 Mitigating Risk and Enhancing Financial Stability in the Global FX Market
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How the CLS Settlement
System Works
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Following a FX trade, Settlement Members submit payment
instructions to CLS. These payment instructions are then
authenticated and matched by CLS and stored in the system
until the settlement date.
The CLS daily settlement cycle operates with settlement and funding occurring during
a five-hour window when RTGS systems in the CLS settlement currency jurisdictions are
open and able to make and receive payments. This enables simultaneous settlement of the
payments on both sides of a FX transaction.
Each Settlement Member holds a single multicurrency account with CLS. At the start and end
of a normal settlement day, each Settlement Member has a zero balance on its account. Under
normal operations of the settlement service, CLS starts and ends the day with a zero balance
in its central bank accounts and in its Settlement Member accounts. Settlement Members may
submit payment instructions relating to their own FX transactions, as well as the FX transactions
of their third party customers, directly to CLS.
CLS settles on average
between USD 4.5 trillion
and USD 5 trillion every
working day, 99% of all
payment instructions are
settled between
CET 07.05 and 07.50
On each settlement date, CLS simultaneously settles each pair of matched payment instructions
by making the corresponding debit and credit entries across Settlement Members’ accounts at
CLS. The settlement of the payment instructions and the associated payments are final across
CLS’ books. This finality is one of the most important elements of the CLS system.
FX Contracts
CLS Member
or client trade
CLS Member
or client trade
trade agreed
CLS payment instruction*
CLS payment instruction*
CLS system
Payment instructions matched
Payment instructions stored
until settlement date
Funding
(via RTGS systems)
Payment instructions settled on settlement
date (contractual obligation extinguished)
Pay-in and pay-outs from/to Settlement
Members either direct of via nostro
*Mandatory SWIFT standards
10 Mitigating Risk and Enhancing Financial Stability in the Global FX Market
Funding
(via RTGS systems)
Grand Central Station,
New York, USA, 1913
The compass in the small point at
the top correlates with the true north
direction with 100% accuracy.
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Effective Financial Systems
Depend on Safe and Efficient
Payment Systems
A well-managed payment system minimizes the effects of
economic disturbances that could otherwise disrupt domestic
and international financial markets. Recognizing its role
as a critical infrastructure at the center of the FX market,
performance, resilience and security are all of paramount
importance to CLS.
»» A real-time secure global system able to flex to meet the demands
of an evolving market
»» Mirrored environments in multiple data centers to deliver the highest levels
of resilience and business continuity
»» A standard legal framework for settlement finality
»» A comprehensive regulatory framework:
–– CLS is supervised and regulated by the Federal Reserve Bank of New York
–– CLS is subject to a unique cooperative oversight arrangement with the central banks
whose currencies are settled in CLS (Oversight Committee)
»» A robust governance structure combining an appropriate level of flexibility with
high standards of business transparency, accountability and independence
»» Compliance with the Core Principles for Systemically Important Payment Systems6 which
provides guidelines for the design and operation of safer and more efficient systemically
important payment systems
»» Compliance with the Interagency Paper on Sound Practices to Strengthen the Resilience
of the US Financial System7 which recommends reliance upon dual data centers with
synchronous data replication
6
T he Core Principles for Systemically Important Payment Systems was published by the Committee on Payment and Settlement Systems
(CPSS) in 2001. In April 2012, the CPSS and the Technical Committee of the International Organization of Securities Commissions
(IOSCO) published: “Principles for Financial Market Infrastructures”. It replaced the previously published Core Principles. CLS is
currently working to attain these new standards.
7
T he Interagency Paper on Sound Practices to Strengthen the Resilience of the US Financial System was jointly published by the Board
of Governors of the Federal Reserve, the Office of the Comptroller of the Currency and the Securities and Exchange Commission in the
United States in April 2003.
12 Mitigating Risk and Enhancing Financial Stability in the Global FX Market
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Greenwich Shepherd Gate Clock
United Kingdom, 1852
The first to display Greenwich
Mean Time to the public.
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