BANKING
CLS in Asia: Looking Ahead
March 7, 2005
Fredric Fanthome, Caps

Taking Stock of CLS Success

Continuous-Linked Settelement (CLS) has so far been an unqualified success. When it went live on 9 September 2002 after months of delays, it had more than its fair share of sceptics. Today it is clear that CLS has surpassed the most optimistic expectations of its founding members. CLS is the industry standard for FX spot and forwards settlement in 15 of the world's most traded currencies, accounting for more than 60 per cent of global FX transactions. It has reduced the value of payments required for settlement by more that 95 per cent. Currently CLS banks settle on average over 170,000 payment instructions daily with a gross currency value of over $1.9 trillion¹.

The number of users has grown from the initial 39 member banks to over 330 institutions² of which 69 are settlement members and the remaining are banks, funds, brokers, and corporates using the service as third parties.

Current Asian Involvement

However, in the Asian context, the impact has not been as far reaching. There are only three currencies from non-Japan Asia within CLS, (Singapore dollar, Hong Kong dollar & Korean won) and the currencies of both China and India are not part of the system. It is unlikely they will be included in the next two to three years, given that in both India and China, a number of significant changes will have to be made in many areas including legal frameworks, regulatory powers, potential participants' financial health and payments systems' robustness for them to meet CLS's strict standards for inclusion.

In terms of settlement members and third parties, the Asian tally stands at five members: Kookmin Bank and Korean Exchange bank in Korea, and DBS Bank, UOB Bank and OCBC Bank in Singapore. Even if one includes Standard Chartered Bank and HSBC within the Asian tally vis-à-vis the HKD, we have a total of seven banks out of 69. At the branch level, a number of foreign banks are certainly involved in Asia, but the number of branches open in Asia is a fraction of the branches worldwide.

This pattern is reinforced by a glance at the global foreign exchange transaction statistics. Within the CLS system, the three Asian currencies account for about 1,600 of the 170,000 transactions settled daily, or less than 1 per cent of global volumes. This reflects global foreign exchange transaction volumes, where Asian currencies account for an equally small fraction of transaction volumes. The currency values involved in Asian currency transactions are also typically much smaller that those of the major currencies, with consequently less exposure involved.

Given the limited transaction volumes and values in Asia, and the smaller exposure that the larger financial community has to a failure of a bank in the region, and considering the lack of appropriate regulatory and legal frameworks in many of the regional economies as mentioned earlier, it is fair to say that the key drivers to making CLS compelling in Asia are missing, and hence the lack of broad take up is understandable.

CLS: The Next Phase

Going forward, though, now that it has proven itself a success in achieving its primary goals, CLS is exploring further strategic initiatives. These include:

• Additional Settlement Sessions to extend settlement risk reduction benefits to same day trades in the western hemisphere.
• FXplus, focusing initially on providing a CLS service for non-eligible currencies, NDFs and Options premiums, and later on settlement for Credit Derivatives and IRSwaps.
• Additional CLS Currencies (Mexican peso, Chilean peso, Israeli shekel, Turkish lira among others)

These initiatives are essentially involved in increasing the CLS footprint geographically and product-wise, thus bringing the CLS benefits to an increasing section of the global financial markets.

Additional settlement sessions will reduce the settlement risk on the estimated $240bn-worth of trades that are done outside CLS in same-day trades, IO swaps and US dollar-Canadian dollar trades. The attendant benefits like the freeing up of credit lines, better liquidity management and increased trading limits will also accrue.

The new currencies under consideration would take the proven CLS benefits to Central and Latin America for the first time with the inclusion of Mexico and Chile. Israel and Turkey could be the beginning of a push in Eastern Europe and the Middle East.

While the two initiatives summarised above are lateral extensions of existing service models, the most significant push is to bring new products into the CLS offering, opening up a new order of benefits for members, as settlement risk gets eliminated from a whole slew of financial products.

The Effect in Asia

What does this mean for Asian participants? The additional sessions and the four CLS currencies being considered for the next wave will be of limited value to Asian institutions. In fact, the prospect of having to operate a 24-hour shop to accommodate the later settlement sessions is likely to be a source of discomfort for Asian members, with its cost implications for what will be insufficient gains. CLS is therefore considering making the additional sessions optional.

Similarly, there is negligible trading in the parts of the world of the four currencies - Turkey, Israel, Chile and Mexico - so far being considered for the next wave in CLS, so the upgrading costs that will necessarily be incurred to accommodate them will again be for little added benefit.

On the other hand, there should be significant interest in the progress of FXplus which envisages providing a service for both non-eligible currencies and new products.

The key value proposition that CLS brings to a financial system and its participants is the reduction of cross currency settlement risk and the consequent reduction of systemic risks. The need for this is as keen in Asia as it is anywhere else. Indeed, given the relative quality of credit in the region, the need for a mechanism to reduce counterparty exposure is probably greater than elsewhere. However, given the inadequacies in the legal frameworks and the financial systems of several Asian countries, it is unlikely that any of these currencies will qualify for inclusion into CLS for the next two to three years, if not longer. In such a situation, a 'CLS for non-CLS currencies' becomes an attractive proposition. It is probable that many more Asian entities will be able to participate in a bilateral netting environment than can currently participate in CLS. If the further step of providing an infrastructure for a CLS-like multilateral netting environment for the many currencies non-eligible for CLS can be undertaken, it is certain to evince considerable interest in the region, both among market participants and central banks.

With regard to additional products, the inclusion of NDFs and other derivatives, especially credit derivatives into CLS will be of as much interest here as elsewhere in the world. Asia has an active NDF market, and like banks in the west, in the increasingly margin-squeezed financial markets of today, players in Asia have also turned to high margin products including credit derivatives and other complicated structured products in a big way to improve their bottom lines. There is an increasing danger that less sophisticated institutions' risk management capabilities may not be able to keep up with the pace of business development. This could potentially lead to a miscalculation of catastrophic consequence. The need for a CLS-like entity to protect the financial systems in the region in the event of such a sudden counterparty failure then becomes very real.

In addition, the standardisation of processing and payments that CLS is likely to bring to the operations across the products it takes on, and the synergies in processing that are likely to emerge, will probably reduce operating costs and complications significantly.

Third-party Membership

Another avenue for increased participation in CLS is via third party membership. There are significant cost advantages to being a third-party member, especially for small players, and corporates as they do not have to make the investments necessary for direct membership, yet they receive the benefits of payment-versus-payment settlement risk reduction. Currently there are 18 banks offering third-party connectivity to CLS, sharing between them a total of over 250 third-party members, with the list growing every month.

Intuitively it would seem that this would be a very attractive way for smaller Asian banks to participate in CLS. However the take up in the region has been somewhat limited. At the risk of oversimplification, the reason for the slow uptake is likely to be a combination of two factors: the absence of Asian banks' domestic currencies in the CLS pool, and the reluctance to get tied in to a large, foreign, essentially competitor bank for all FX transactions settlement.

A Medium-term Timeline

CLS's strategic initiatives for the coming years hold significant promise for the financial community. The direction it is taking will broaden its appeal, particularly in Asia, where in its current state the involvement is constrained by the many factors discussed above.

None of these initiatives, however, will be easy to bring to completion. CLS itself is a sobering reminder of the time it can take to bridge the gap between intention and execution. Currently the CLS Board is in the early phases of determining the course of action, priorities and timelines for each of the above initiatives.

In the case of the additional sessions, it has been determined that the sessions are technically viable. A business case for the initiative is due to be drawn up, along with the technical specifications required to implement the sessions. Early estimates are that the time to implementation is between 18 months and two years.

FXplus, with its broader scope and large number of products presents a bigger challenge. An initial focus on bilateral netting, NDF and FX Option premiums, following much the same progress path (customer requirements, business case, technical specifications, build and delivery) is estimated to take 18 months to completion, and the next phase where credit derivatives, interest rate swaps and other products could be brought in will take even longer, probably another year to 18 months. Adding new currencies to CLS, is also expected to happen no sooner than late 2006. In summary, it would appear that the time to operational readiness for any of the above initiatives would be close to two years, and possibly longer.

The Future for CLS in Asia

In conclusion, CLS, as it is today, has already proved its value to the financial community. However the participation of non-Japan Asia has been largely limited.

CLS's strategic initiatives, however, envisage growing the product range and currency envelope. Should the inclusion of non-eligible currencies and the derivative products that are becoming increasingly popular in the region come to pass over the next two to three years, the argument for CLS in the region will become compelling.

Further, with the economies of China and India set to become larger and larger centres for trade, industry and financial activity over the coming years, the proportion of Asian transactions in the world market is likely to grow, and take on more significance than it has in the past.

The need for CLS in Asia is real and growing especially when you consider that, in the medium term, Asia will start representing a larger section of the international financial market than it does today. The motivation for greater CLS involvement in Asia will then become powerful both for the international financial community and the local players. Thus, while the engagement between CLS and non-Japan Asia has been somewhat limited so far, there is there is bound to be increased engagement from both sides over the coming years.

¹ www.cls.com/news, "CLS Bank Settles New Record Value", 15th December 2004

² Olaf Ransome, "Pioneering Spirit needed to Avert CLS Complacency", 24 January 2005, GTnews.com

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