Safe Settlement

CLS Bank and its technology partner, IBM, have completed the first of five intermediate testing stages before the launch of the Federal Reserve-regulated, bank-owned financial utility.

Upon going live, CLS Bank will intermediate the bulk of the world's foreign exchange transactions. Globally, foreign exchange reaches an estimated average daily turnover of $1.2 trillion, according to the Bank for International Settlements.

CLS, or continuous linked settlement, promises to mitigate the risk that one side to a foreign exchange transaction receives funds from its counterparty and then finds itself unable to reciprocate. Under CLS, both sides to the transaction will have to pay in their side to a trade before either receives funds. (See Cover Story, November 2001 BS&T.)

CLS Bank will initially settle payment instructions in seven major currencies (U.S. dollar, Japanese yen, euro, British pound, Swiss franc, Canadian dollar and Australian dollar). In addition, the currencies of Denmark, Norway, Singapore and Sweden became eligible for inclusion last October.

Originally scheduled to go live two years ago, CLS Bank is undergoing rigorous performance testing, executives say. "Whilst it has gone remarkably well and no one has ever been here before, we are erring on the side of caution," said Jeffrey Manton, a spokesman to New York-based CLS Bank. "The criteria will not be compromised."

Yet the long delay has resulted in the loss of programmers as well as bank executives. "You have turnover-the person who was originally the CLS project manager, and who lived and breathed this stuff every day. After a year or two you bring in another," said G.M. Stetter, executive vice president of strategic planning and corporate marketing at Fundtech, Jersey City, N.J. "Any project that goes on that long starts to lose energy and momentum."

In early 2001, a new management team at CLS Bank imparted its renewed sense of mission to IBM, which in turn committed additional technical resources. "IBM literally put hundreds of people on the project," said Manton. As a result of these efforts, CLS Bank appears to be finally getting off the ground.

The first testing stage brought the core system to agreed-upon scalability and volume levels. Nine banks participated in the pilot. The second stage, which involves systems integration testing, is now underway. "We have 11 of our pilot shareholders linked for the first time with six of the central banks' real-time gross settlement (RTGS) test systems, actually handling settlement and payments to the CLS timeline," said Manton.

The third stage, an end-to-end trial, will involve real trades using real money, albeit in small amounts. "This is where CLS Bank has to prove to the Federal Reserve CLS' primary regulator that we are fit," said Manton. "It has to be proven it can handle scalability, volume, contingencies, a normal day and an abnormal day."

In the fourth stage, the approximately 70 shareholder banks will get a similar chance to prove that their systems are ready. By doing so, they can become CLS members as well as owners. "We've already had 43 of them up on our member testing system," said Manton. Several banks, including investment banks and smaller institutions, have chosen to sit out the opening round, observers say, because they don't expect to have the FX volume to justify becoming member banks.

The fifth and final stage will be a "controlled, unscripted, live" round of testing, involving an estimated 30 to 40 CLS member banks. By the end of the year, CLS Bank also hopes to include third party transactions in the mix, allowing member banks to ensure that their customers' systems are ready to fully participate in a new, reduced-risk trading environment.

A successful, global launch in 2002 would be great news for the banking community. "We're all hoping that the testing stays consistent, so that there's no major change at the eleventh hour," said Fundtech's Stetter.

Indeed, the terrorist threat to the financial community has made safe settlement more important than ever. Without a system such as CLS, counterparties to a financial institution under attack might hold off from making any payments out of uncertainty as to whether the trade would go through. "If you had CLS there, you could still continue making payments," said Manton. "If the other side can't pay, you get your principal back." (The term "principal" refers to the money held in a bank account at a central bank, as CLS Bank only holds instructions on the scheduled movement of funds rather than the funds themselves.)