The risk of foreign exchange settlement can be reduced today if third parties connect to the continuous linked settlement (CLS) system, says consultant Peter Davey, but there are a number of key issues to consider in the selection process.
CLS is crucial to reduce the risk of settling foreign exchange transactions. If payment in one currency only takes place when payment in another currency happens simultaneously, settlement risk is reduced or eliminated. More than 50 settlement members are already using the system and a high volume of transactions is supported. But adoption by third parties is much slower.
Many third parties do not see FX as a profit centre and believe there is less material risk for them so they are less keen on investing in linking to the CLS system. Many of these entities are not regulated, so regulatory pressure is less effective. The benefits of providing a seamless connection to CLS, however, may persuade them.
But there are key process issues to consider before connecting to CLS. The need for a flexible system
CLS market practises such as compensation processes, claims and fourth party services are still evolving. Rescinded and failed transactions are particularly affected. Currently, the working assumption is that settlement will take place outside CLS on the same value day. But this may not always be possible. It is therefore essential that third parties use a solution that can evolve with changing market practice. Use of a control branch
If a third party can route most of its branches’ trading and settlement via CLS, the efficiency of CLS will be enhanced. But this requires a control branch approach, which can be complex, unless the third party already trades and settles in a single name. Effective liquidity management
CLS eliminates FX counterparty risk but complicates the liquidity management process for a third party, especially if the third party plans to extend such services to fourth parties, either in-house or externally. Sometimes, it is harder to enforce performance standards across group companies than with a smaller company or single entity. Serving existing customers
Non-CLS FX transactions related to non-CLS currencies and counterparties will continue for the foreseeable future. It is important to recognise that workloads related to CLS FX settlements are different to non-CLS settlements. Fourth party services
Many of the third parties considering connecting to CLS want to offer fourth party services. However, the complexity of offering such services deters them. Risk management is arguably more complex for a third party offering fourth party services than for a settlement member.
This is because a third party has to ensure that:
- Its total exposure, including those of its fourth parties, stays within the limits set for the third party by the settlement member
- Each fourth party stays within the third party’s own risk tolerance limits for that fourth party
But these issues can resolved.Business Process Management
A useful solution to these issues is to enhance Web browser access to CLS through a business process management (BPM) system. A BPM system sits on top of existing legacy processes and monitors the status of trades and settlements. It can monitor, manage and control the status of CLS and non-CLS trades and settlements through a single system in real time.
Digital dashboards can alert users to transactions approaching or exceeding a deadline, for example, and identify exceptions. The alerts can be flagged on the dashboard or sent to specific individuals via e-mail or text message, for example. The latter is especially useful out of hours.
BPM solutions can also initiate actions in underlying systems. In the event of a rescinded or failed transaction, for example, an alert is sent to the appropriate person to decide whether it should be settled today outside of CLS or tomorrow inside CLS. A BPM solution can also trigger messages internally and externally as well as delivering updates about the underlying systems.
Most BPM solutions have been developed using modern technology, so it is easy for firms to change the parameters of the existing system and extend functionality. As the processes and practises relating to CLS change, automated actions can be modified. This is much easier to do in a BPM solution rather than in underlying systems.
A BPM solution will also help firms overcome the limitations of some browser systems provided by settlement members.
This is because they can:
- Integrate their systems with the third party's own systems
- Initiate actions into the third party's own systems
- Deal with both CLS and non-CLS trades and settlements, which will reduce manpower requirements
- Send user-friendly alerts via different channels
Third party connectivity to CLS offers reduced counterparty settlement risk, which is a key benefit, but also enables firm to increase their trading capacity in FX and other instruments. Deciding whether and how to link up to CLS is not easy but the use of BPM systems can smooth the way to seamless connectivity. Peter Davey of Peter Davey & Associates is a specialist in payments, settlements and clearing. He was formerly deputy CEO at ECHO, the precursor to CLS, and has conducted several CLS projects, including a KPMG survey on CLS. He can be contacted on (07968) 945589