Exchanging Partners

Every 36 hours, CLS Bank settles foreign exchange trades having a value equivalent to the gross domestic product of the entire United Kingdom. In the year since its launch in September 2002, CLS Bank has settled seven million foreign exchange trades worth $160 trillion, representing almost 40 percent of the estimated total global value of FX trading. That's an impressive start for the bank-owned venture, and an affirmation of the success of the underlying technology.

Next year's ambitious plan: to double CLS Bank's settlement volume. But that's going to take increased participation from banks, exchanges and corporations alike, according to speakers at last months Bank Systems & Technology/BAFT Executive Technology Forum.

Also, through working groups, CLS Bank plans to explore three important issues for the FX industry: information services, liquidity management and straight-through processing (STP).

CLS Bank's Continuous Linked Settlement System (CLSS) protects banks involved in high-value currency exchange against the risk of either side going bankrupt before settlement, a situation that could leave one side empty-handed with its own balance sheet in jeopardy. The failure to settle trades of sufficient magnitude could be devastating for a bank, and the failure of a bank can be devastating for an economy.

Through CLSS, both sides must wire their respective currencies to CLS Bank before CLS Bank will settle the trade. Such a strong defense against systemic market risk has been the main reason that many national bank regulators have been so supportive of the CLS Bank concept.

"Our regulators expect us to make more progress and get to a higher percentage of total daily value," Jonathan Butterfield, executive vice president, marketing and communication, CLS Bank International (New York), told the ETF audience.

GAINING CURRENCY

To do so, CLS Bank plans to incorporate additional currencies. At the start, it had seven; it now has 11. Over the next year, it hopes to welcome the currencies of Korea, New Zealand and Hong Kong.

"In the case of both New Zealand and Hong Kong, they, in fact, have had to enact new legislation to provide the degree of finality in the settlements in their local systems," Butterfield said. "You have to have an environment and a legal infrastructure in all the legal jurisdictions in which we operate to be sure that indeed, settlement risk has been eliminated."

But it may prove more difficult to extend the benefits of CLS Bank to foreign exchange transactions involving currencies such as the Chinese renminbi, for which pre-approval and notification at the moment of settlement is required. "We simply cannot stop the settlement cycle in order to satisfy some of the sorts of reporting requirements that you can find in non-freely floating currencies," said Butterfield.

Nevertheless, banks and corporations trading CLS Bank-eligible currencies can lower the relative cost of doing business. "As banks start to evaluate the credit they extend to their trading partners, one of the things they're able to do is lower, if not eliminate, settlement limits within those trading lines," Butterfield says. "Those limit reductions we perceive to be increasingly redeployed as trading lines."

On the data side, the information services working group will seek a greater understanding of the aggregated FX market based upon the data that CLS Bank collects.

"We're beginning to truly see and understand a seasonality in the foreign exchange business that I don't think anyone has seen quite so starkly before," noted Butterfield.

While CLS Bank must protect the confidentiality of FX market participants, the aggregated data may have some useful applications, particularly when comparing contract activity in currency pairs over time. The second working group will work on liquidity management issues, including the question of whether to establish a second, "North America-friendly" settlement cycle, which would better support U.S. and Canadian dollar same-day trading, and permit North American banks to realign liquidity before the close of the U.S. markets.

STRAIGHT-THROUGH BENEFITS

Finally, the third working group will examine STP initiatives, along with ways in which industry players such as New York-based FXall can funnel transaction volume to CLS Bank to the overall benefit of the industry.

Indeed, the full-automation benefits of STP have become critical for banks hoping to remain profitable participants in the foreign exchange market, reported Jack Lemonik, chief technology officer at FXall, which provides automated foreign exchange trade execution services to market participants.

Furthermore, STP can't only happen with the sell-side (banks providing quotes for foreign exchange transactions), but must also reshape the buy-side (including corporations). "That's really critical, because by allowing the buy-side firms to do [STP], then ultimately we save money for the banks by making their workflow back and forth more efficient," Lemonik told the ETF attendees.

Among the firms actively helping corporations achieve STP has been New York-based Citigroup (assets: $1.14 trillion). Indeed, the bank's first corporate customer for CLS services is scheduled to go online by November, and such enrollments should benefit the financial markets as a whole.

"Bringing corporate users into the dealer community will further make CLS more efficient, reduce liquidity swings in the market, and help improve the overall STP rates for foreign exchange processing," reported Michael Knorr, director and global CLS product management head, Citigroup Global Transaction Services.

Settling trades through CLS also helps participating corporations. "The CLS process can greatly enhance a corporate treasury's ability to do foreign exchange more efficiently, automate the process and reduce the utilization of their overdraft line," says Knorr.

There are several ways that a corporation can connect to CLS Bank. First, there's the option of getting a SWIFT connection, which has the added benefit of providing access to other SWIFTNet services besides foreign exchange. But there are other avenues, including intermediaries such as FXall or through London-based Misys' trade matching service. Citibank connects to both, and is more than happy to execute foreign exchange transactions through any capable channel.

"This insulates customers from the need to do their own SWIFT interfaces, and utilizes an already existing channel that's available to get instructions to their CLS provider [e.g. Citibank]," Knorr told the audience.

Plus, there's also the possibility that if CLS Bank picks up enough steam, it could create direct connections to corporate clients. "Another way to connect to CLS is to take it a step further and take it to further integration with treasury platforms," said Knorr. "For us as a provider, it's critical that we have the right linkages to these applications, as well."