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THE PAYMENTS RISK COMMITTEE
FOREIGN EXCHANGE SETTLEMENT RISK
Report by the FX Settlement Risk Task Force, New York
February 2005
_____________________________
The Payments Risk Committee is a private sector group comprising senior managers from several major banks in the US,
sponsored by the Federal Reserve Bank of New York. The Committee identifies and analyzes issues of mutual interest related to
risk in payment and settlement systems. Where appropriate, it seeks to foster broader industry awareness and discussion, and to
develop input on public and private sector initiatives. Current members of the Committee are Bank of America N.A., The Bank
of New York, Bank of Tokyo-Mitsubishi, Citibank N.A., Deutsche Bank AG, HSBC Bank USA, J P Morgan-Chase, State Street
Bank and Trust Company, UBS AG, and Wachovia Corporation.
1
1. PREFACE
The Federal Reserve Bank of New York established the Payments Risk Committee in
1993 as a means of inviting the input of commercial bankers in formulating
recommendations for improving the quality of risk management in payment and
securities settlement systems. Senior executives with broad payments systems
experience from banks active in the payments business were invited to participate in the
Committee. In addition to its primary role of formulating risk reduction
recommendations, the Committee’s objectives are to promote better understanding of
payments risk issues among market participants; enhance knowledge of the workings of
particular payments systems in the U.S. and internationally and to circulate research on
payment systems to participants and the public; promote better communication between
private sector institutions and the Federal Reserve Bank and, where appropriate, other
bank supervisors within the U.S. and internationally; and provide a forum for discussion
of technical issues in payments systems.
The Committee is sponsored by the Federal Reserve Bank of New York and is composed
of representatives of Bank of America N.A., The Bank of New York, Citibank N.A.,
Deutsche Bank AG, HSBC Bank USA, J P Morgan-Chase, State Street Bank and Trust
Company, UBS AG, and Wachovia Corporation. There is also participation by the
Federal Reserve Bank of New York and the staff of the Board of Governors of the
Federal Reserve System. The Committee is supported by a Working Group of mid-level
executives, which conducts research regarding topics designated by the Committee and
drafts reports and studies for Committee approval.
1.1 The Working Group and Foreign Exchange Reduction in Settlement Risk Task
Force
In 2004, the Committee requested that the Working Group undertake a survey among its
members to assess the impact of CLS and overall progress in reducing foreign exchange
settlement risk (i.e. the risk of paying the currency sold but not receiving the currency
bought). CLS is a private sector industry utility which went live in September of 2002
for the express purpose of reducing the risk associated with foreign exchange transactions
by ensuring that one leg of the currency transaction will settle if, and only if, the other leg
also settles. CLS includes CLS Services which provides the trade matching and payin
schedules and CLS Bank, a limited purpose bank regulated by the Federal Reserve Bank
of New York, which provides for settlement.
The Committee reasoned that enough time had elapsed from the inception of CLS to have
an appropriate amount of experience with the new utility to understand its impact. In
addition, the Committee determined that it made sense to conduct the survey at a point in
time that would be consistent with the BIS Triennial Survey.
The Working Group assembled a Task Force to draft a survey, the results of which would
be compiled by the Federal Reserve Bank of New York. The Working Group recognized
the need for a simple questionnaire so as not to unnecessarily burden the participant
institutions which were also compiling significant amounts of data for the Triennial
Survey. However, the Task Force also determined that certain quantitative data would be
2
required to substantiate the findings. As a result, the Task Force called upon the
resources of CLS to provide certain generic information. A full list of the members of
the Task Force follows this preface.
1.2 Acknowledgements
Valuable guidance and support was provided by the members of the Payments Risk
Committee and the Working Group. Additionally, considerable assistance was furnished
by the Operations Managers Working Group of the Foreign Exchange Committee and
CLS Bank.
The conclusions and recommendations set forth in this Report do not necessarily
represent policies of the institutions represented nor the policies or views of the Federal
Reserve System.
3
MEMBERS OF THE TASK FORCE
Chairman Ms. Kathleen Voigt, State Street Bank and
Trust Company
Bank of America Ms. Susan Hutchison
The Bank of New York Mr. William Koleba
Mr. Philip Scott
Mr. Timothy Hallett
Bank of Tokyo-Mitsubishi Mr. Paul Duddy
Citibank Mr. Patrick Perella
CLS Bank Mr. Jim Hughes
The Federal Reserve Bank of New York Mr. Lawrence Sweet
Mr. Morten Bech
Ms. Lindsay Dratch
Ms. Radhika Mithal
HSBC Mr. Wayne Ferguson
J P Morgan Chase Mr. Gary Smeal
State Street Bank and Trust Ms. Kathleen Voigt
UBS AG Mr. George Meaders
Mr. Roland Roetheli
Wachovia Bank Ms. Yoko Horio
4
2. EXECUTIVE SUMMARY
The foreign exchange settlement process has undergone a radical change since September
2002 when CLS began live operation. This paper addresses the experience of the
Payments Risk Committee members as participants in the CLS process. Issues relating to
participation, credit, liquidity, and operations were addressed. Overall, the experience
has been positive and participants note a reduction in settlement risk as a result of CLS.
There has been some replacement of settlement risk with other risks but these risks have
proved to be manageable. Liquidity risk remains an area of concern and may require
further review. While CLS has been recognized as a major industry utility, work remains
to be done. The marketplace in general would benefit from additional participants in the
CLS process. Efforts to encourage additional participation should be ongoing.
3. CHARTER AND SURVEY APPROACH
The mandate of the task force was twofold. First, the task force was to examine to what
extent and how effectively banks have used CLS to reduce their foreign exchange
settlement risk exposures and whether or not there was potential to further reduce
settlement risk by using CLS. Second, the task force was to explore, if in the course of
reducing settlement risk by using CLS, whether other risks, such as operational or
liquidity, had been introduced into the payments environment.
The task force reviewed possible approaches to drafting the survey, including
dissemination of a quantitative-based survey approach similar to the one originally used
to gather data in support of the 1996 and 1998 reports issued by the Committee on
Payment and Settlement Systems of the Bank for International Settlements. While
members agreed this approach would provide significant quantitative data, members were
concerned that the work load associated with completing this type of survey would be
overly burdensome to the participating institutions especially since they were already
involved in compiling data for the Triennial Survey. As a result, the task force members
opted to draft a more qualitative survey which could be augmented by certain generic
quantitative data furnished by CLS. Once the survey was in draft form, the task force
also consulted with the Operations Managers Working Group of the Foreign Exchange
Committee to solicit their buy-in and cooperation.
The task force elected to focus on four main areas and allow a fifth section for open
ended discussion of any topics participants felt had not been adequately addressed in the
survey document. The task force further determined that only those institutions
represented on the Payments Risk Committee would be requested to complete the survey.
4. SURVEY RESULTS
4.1 OVERVIEW
The task force concentrated on utilization of the CLS system by the participants, changes
in measurement of credit risk since the inception of CLS, changes in intraday liquidity
patterns and management thereof, and the operational impact of CLS. Additionally,
5
participants were encouraged to provide additional commentary on any aspect of CLS
which may have created additional risk or cause for concern. The survey was returned to
the Federal Reserve Bank of New York in order to ensure confidentiality of proprietary
data. The data was then compiled and preliminary analysis shared with the task force.
All nine of the institutions which participate in the PRC responded although given that
one member was still in testing its responses were limited by its lack of a live
implementation. The task force reviewed the preliminary analysis and a discussion on
each of the findings follows.
4.2 DISCUSSION OF SURVEY FINDINGS
4.2.1 Participation
Each of the respondent institutions is participating in CLS and all but one is a settlement
member. There was no discussion relative to the non-settlement member’s decision to
participate in CLS as a third party.
While each respondent is participating in CLS, the value and volume of the foreign
exchange trades settling through CLS varies significantly. Only one institution indicated
it is submitting all of its eligible foreign exchange trades to CLS including those done
between the institution’s own branches. Of the remaining institutions, approximately 40
branches across all seven institutions are participating in CLS. The primary reasons for
branches not submitting to CLS are insufficient volumes in the branch to justify the
required infrastructure and procedural changes, the ineligibility of same day trades, and
competing priorities with other bank initiatives.
In terms of the value of the trades being submitted, the majority of institutions were
submitting in excess of 25% of the gross value of their eligible trades while three
institutions were above the 75% value including the one institution that submits all of its
eligible deals to CLS.
The respondents had mixed experiences with regard to increased trading values since
CLS began operations, with more than half reporting no change and the remaining
reporting an increase. Only one institution believed the increase was due to the
introduction of CLS while the others cited more favorable business conditions.
Many of the institutions have actively pursued offering third and fourth party services to
their customer base. Some are experiencing 50% of their third party clients’ activity
settling in CLS and there is a major push by these institutions to build on this in the near
term. There was some discussion that third party activity has allowed some institutions
to meet their committed volumes to CLS even though their own branches are not fully
participating in CLS.
The task force spent a good deal of time discussing the somewhat limited participation in
the CLS process by many of the respondents and the reasons given, including the
inability to include same day trades, counterparties not being CLS participants,
insufficient volumes to justify the changes required, minimal incentive for the front
office, and minimal direct pressure on the part of the regulators. Given the time and
resources devoted to the implementation of CLS and the fact that it has become the
industry standard for settlement of foreign exchange items, the task force believes that
6
financial institutions need to be more aggressive in submitting all of their eligible activity
to CLS.
4.2.2 Credit
In general, the respondents indicated a decrease in the overall settlement risk for their
respective institutions as a result of the CLS process although for those offering
third/fourth party services they also noted related increases in certain intraday exposures.
The respondents were also split on the measurement of credit limits for trades settling in
CLS. More than half of the institutions responding indicated that they no longer calculate
settlement risk for trades settling in CLS although they do maintain a settlement line for
each counterparty to accommodate trades that settle outside of CLS. Those institutions
continuing to calculate settlement risk on CLS settled trades do so because of system
constraints or because the counterparty retains the ability to unilaterally rescind trades
leaving them subject to traditional settlement methods.
Most of the institutions participating in the survey also participate in the in/out swap
process and maintain settlement lines for these trades. While the institutions
acknowledge that the in/out swap process reintroduces settlement risk, most reported that
it is less than 10% and is manageable.
Those institutions offering third/fourth party services are selective about their client base,
have implemented controls to limit the amount of risk they assume on behalf of the client
and have also implemented intraday caps to control their CLS exposure. There was a
good deal of discussion relative to the increase in intraday exposure as a result of this
activity.
There were two other areas that the task force reviewed relative to credit exposure, one
relating to non-CLS settled trades and the other relating to netting arrangements. In
general, participants acknowledged that there are dedicated, hard settlement limits in
place for non-CLS settled trades and the criteria used is similar to that used for other
extensions of credit. Most of the institutions are measuring the lines on a daily basis
although a couple noted that they use a time-line methodology and two are planning to
migrate to a time-line basis in the future.
As there are numerous currencies not eligible for CLS settlement, most of the participant
institutions continue to utilize a bilateral netting process to minimize their exposure.
However, they also indicated that there are inherent operational difficulties associated
with the netting process. Further, there was no consensus on development of netting
capabilities within CLS or reintroducing another utility to accommodate netting of non-
CLS currencies.
4.2.3 Liquidity
In reviewing the survey results, the task force noted that the CLS process has had a
significant impact on the management of intraday liquidity by virtue of the requirement
for timed payments and the availability of liquidity to effect the payments. While gross
payouts and receipts are substantially lower, the individual payins and payouts are
7
generally larger and time critical. Notwithstanding these changes, respondents agreed that
liquidity risks were manageable.
It was noted that most of the respondents are clearing only a few currencies themselves
and utilize a nostro agent to make their other payments. The two most frequently selfcleared
currencies are the USD and the Euro. In discussing the timed payments, task
force members noted that there are increased costs as a result of the use of intraday credit
at a nostro, increased debit cap usage, or pledged collateral.
The respondent settlement members are all utilizing the in/out swap process to reduce
their liquidity needs and have found it to be effective and the risks manageable. Its
discontinuance would increase their liquidity risks. Most of the respondents indicated
that the in/out swap frequently brings them to the trade-down limits.
Respondents were mixed with regard to the other risks associated with making the timed
payments although they were in agreement that the risks were manageable. Most of the
respondents indicated that they had experienced late pay-ins with the primary reason for
the failure being a systems issue although communications and operations were also
cited.
Not all respondents have had a positive experience in all of the currencies but the
problems are somewhat isolated. Further, there is no consensus on liquidity constraints
as additional currencies are introduced with half indicating that they will experience more
pressure while the other half indicate they expect no change.
Most respondents indicated their institutions would benefit from an intraday liquidity
market; however, they are not currently using any other liquidity tool to manage their
positions.
4.2.4 Operational Impact
The survey indicated some improvements on the operational side particularly with regard
to reconciliations, decreases in investigations, and decreases in losses associated with
foreign exchange trades. There was no indication that there were corresponding staff
reductions as a result of these operational efficiencies.
In fact, most respondents indicated that they have either extended hours or increased staff
to accommodate the CLS process. Business continuity was also factored in and a number
of institutions utilize multiple branches to perform control branch functions. The model
appears to be that one site has primary responsibility with the others serving in a
contingency capacity. There was no discussion on a follow the sun approach.
Other efficiencies include improvements in straight through processing and the
elimination of the MT 300 confirm. Most institutions also reported a decrease in
payment activity as a result of CLS with six institutions reporting a decrease of over 10%.
There does not seem to be any significant change in the timing of the overall flow of
payments.
The survey found that this set of respondents finds the CLS eco-system to be resilient and
reliable although there are components which on occasion give rise to operational
problems. The survey found that these members are well versed in the best practices
8
relative to handling trades in terms of outages and can accommodate the practices.
Additionally, it was noted that CLS has been responsive to the interagency white paper
on business resiliency and members are generally comfortable with the actions taken to
address business continuity; however, all of the institutions expressed concern about any
potential extended CLS outage in the event of catastrophic failure citing liquidity,
communications, and back office processing issues as key factors. The members also
noted that the new environment has real time linkages for all of the participating RTGS
systems thereby creating increased interdependencies. Consequently, outages in any
RTGS have a significant impact on each of the participating institutions relative to
operations and liquidity.
The survey requested feedback on vendor concentration risk. While the group
acknowledges that the number of suppliers is small and there is a risk that any of the
suppliers could exit the business or could have software defects that create havoc within
the CLS eco-system, the members were evenly divided on this issue as to the magnitude
of the risk and what could be done about it from an industry perspective.
5. CONCLUSIONS AND RECOMMENDATIONS
The task force believes that the CLS system has been effective in reducing settlement risk
in the foreign exchange arena. That effectiveness has been somewhat diminished by the
lack of full participation in the process both by its own members and by a number of
significant counterparties who have not yet subscribed to the CLS process. Task force
members indicated their institutions were in various stages of ramp up at the time of the
survey and progress is ongoing at a number of institutions. CLS’s own data reflects the
continued buildup in both value and volume by these institutions. However, a number of
large counterparties have yet to subscribe to the CLS process either as a settlement
member, user member, or third party.
The task force would like to see increased participation of counterparties by encouraging
them to bring their non-CLS trades into the CLS process. However, respondent
institutions indicate that there may exist a set of non-CLS settled trades (including
proprietary trades and those for corporate and other customers) that may not pose a
significant settlement risk, for example, trades that are settled "on us" or those that are
bilaterally netted. The members felt that bringing such trades into CLS may not be
feasible or warranted, particularly if institutions are able to recognize, manage and
control their exposure in settling those trades. However, verifying that the associated
settlement risks with these trades are well managed may require central banks to conduct
a more in-depth and confidential analysis to assess an institution's effectiveness relative
to the nature, size, duration and concentration of these exposures.
Nevertheless, the task force believes there is a significant set of trades that, from a safety
and efficiency perspective, could and should be settled through CLS. To this end, the task
force believes there are other factors that can significantly improve counterparty
participation in the CLS process. The current ineligibility of same-day trades acts as a
potential obstacle for transactions to settle through CLS. The task force favors CLS
exploring the significance and possibility of additional settlement cycles to bring these
trades into CLS. Another recommendation of the task force is to ensure that front offices
9
are completely engaged in the CLS process. It is essential that traders are fully aware of
and internalize the benefits (operational efficiencies) and the risk reduction that results
from trading with CLS counterparties. There is a need to develop appropriate incentive
structures to encourage the front office to settle trades through CLS (e.g., through pricing,
fees, trading limits or other ways to differentiate between trades settling inside or outside
CLS).
The members contemplated the effectiveness of individually and collectively pursuing
these measures to increase use of CLS. Regulatory support, and possibly pressure, may
also be needed to encourage progress.
The task force believes that CLS is a positive and productive process and stands as a
testament to the private sector’s ability to address and mitigate risk issues. It has resulted
in a number of operational efficiencies, such as the elimination of the MT 300 and
improvements in the reconciliation process. Members are also encouraged by the
reduction in losses as a result of the CLS process. While the task force identified some
increased risks, those risks have been manageable. The only risk that remains of concern
is liquidity and the downstream impact of increased intraday costs associated with
making timed payments when funds are in limited supply and there are competing
priorities for them. The participants acknowledged frequent use of the debit cap in the
early morning hours in order to fund the CLS payments. While liquidity risk currently
appears manageable, the task force believes there should be additional focus on
monitoring the evolution of this risk over time for signs of potential pressure on intraday
liquidity.
It should be noted that this survey was very limited in nature and the findings presented
here may not be indicative of the total CLS experience. The task force believes it would
be useful for regulators or other private sector risk committees in non-US locations to
perform a similar exercise, the results of which could be shared, to gain a more
comprehensive view on this topic.
source: www.newyorkfed.org/prc/fxsettlementrisk.pdf
FOREIGN EXCHANGE SETTLEMENT RISK
Report by the FX Settlement Risk Task Force, New York
February 2005
_____________________________
The Payments Risk Committee is a private sector group comprising senior managers from several major banks in the US,
sponsored by the Federal Reserve Bank of New York. The Committee identifies and analyzes issues of mutual interest related to
risk in payment and settlement systems. Where appropriate, it seeks to foster broader industry awareness and discussion, and to
develop input on public and private sector initiatives. Current members of the Committee are Bank of America N.A., The Bank
of New York, Bank of Tokyo-Mitsubishi, Citibank N.A., Deutsche Bank AG, HSBC Bank USA, J P Morgan-Chase, State Street
Bank and Trust Company, UBS AG, and Wachovia Corporation.
1
1. PREFACE
The Federal Reserve Bank of New York established the Payments Risk Committee in
1993 as a means of inviting the input of commercial bankers in formulating
recommendations for improving the quality of risk management in payment and
securities settlement systems. Senior executives with broad payments systems
experience from banks active in the payments business were invited to participate in the
Committee. In addition to its primary role of formulating risk reduction
recommendations, the Committee’s objectives are to promote better understanding of
payments risk issues among market participants; enhance knowledge of the workings of
particular payments systems in the U.S. and internationally and to circulate research on
payment systems to participants and the public; promote better communication between
private sector institutions and the Federal Reserve Bank and, where appropriate, other
bank supervisors within the U.S. and internationally; and provide a forum for discussion
of technical issues in payments systems.
The Committee is sponsored by the Federal Reserve Bank of New York and is composed
of representatives of Bank of America N.A., The Bank of New York, Citibank N.A.,
Deutsche Bank AG, HSBC Bank USA, J P Morgan-Chase, State Street Bank and Trust
Company, UBS AG, and Wachovia Corporation. There is also participation by the
Federal Reserve Bank of New York and the staff of the Board of Governors of the
Federal Reserve System. The Committee is supported by a Working Group of mid-level
executives, which conducts research regarding topics designated by the Committee and
drafts reports and studies for Committee approval.
1.1 The Working Group and Foreign Exchange Reduction in Settlement Risk Task
Force
In 2004, the Committee requested that the Working Group undertake a survey among its
members to assess the impact of CLS and overall progress in reducing foreign exchange
settlement risk (i.e. the risk of paying the currency sold but not receiving the currency
bought). CLS is a private sector industry utility which went live in September of 2002
for the express purpose of reducing the risk associated with foreign exchange transactions
by ensuring that one leg of the currency transaction will settle if, and only if, the other leg
also settles. CLS includes CLS Services which provides the trade matching and payin
schedules and CLS Bank, a limited purpose bank regulated by the Federal Reserve Bank
of New York, which provides for settlement.
The Committee reasoned that enough time had elapsed from the inception of CLS to have
an appropriate amount of experience with the new utility to understand its impact. In
addition, the Committee determined that it made sense to conduct the survey at a point in
time that would be consistent with the BIS Triennial Survey.
The Working Group assembled a Task Force to draft a survey, the results of which would
be compiled by the Federal Reserve Bank of New York. The Working Group recognized
the need for a simple questionnaire so as not to unnecessarily burden the participant
institutions which were also compiling significant amounts of data for the Triennial
Survey. However, the Task Force also determined that certain quantitative data would be
2
required to substantiate the findings. As a result, the Task Force called upon the
resources of CLS to provide certain generic information. A full list of the members of
the Task Force follows this preface.
1.2 Acknowledgements
Valuable guidance and support was provided by the members of the Payments Risk
Committee and the Working Group. Additionally, considerable assistance was furnished
by the Operations Managers Working Group of the Foreign Exchange Committee and
CLS Bank.
The conclusions and recommendations set forth in this Report do not necessarily
represent policies of the institutions represented nor the policies or views of the Federal
Reserve System.
3
MEMBERS OF THE TASK FORCE
Chairman Ms. Kathleen Voigt, State Street Bank and
Trust Company
Bank of America Ms. Susan Hutchison
The Bank of New York Mr. William Koleba
Mr. Philip Scott
Mr. Timothy Hallett
Bank of Tokyo-Mitsubishi Mr. Paul Duddy
Citibank Mr. Patrick Perella
CLS Bank Mr. Jim Hughes
The Federal Reserve Bank of New York Mr. Lawrence Sweet
Mr. Morten Bech
Ms. Lindsay Dratch
Ms. Radhika Mithal
HSBC Mr. Wayne Ferguson
J P Morgan Chase Mr. Gary Smeal
State Street Bank and Trust Ms. Kathleen Voigt
UBS AG Mr. George Meaders
Mr. Roland Roetheli
Wachovia Bank Ms. Yoko Horio
4
2. EXECUTIVE SUMMARY
The foreign exchange settlement process has undergone a radical change since September
2002 when CLS began live operation. This paper addresses the experience of the
Payments Risk Committee members as participants in the CLS process. Issues relating to
participation, credit, liquidity, and operations were addressed. Overall, the experience
has been positive and participants note a reduction in settlement risk as a result of CLS.
There has been some replacement of settlement risk with other risks but these risks have
proved to be manageable. Liquidity risk remains an area of concern and may require
further review. While CLS has been recognized as a major industry utility, work remains
to be done. The marketplace in general would benefit from additional participants in the
CLS process. Efforts to encourage additional participation should be ongoing.
3. CHARTER AND SURVEY APPROACH
The mandate of the task force was twofold. First, the task force was to examine to what
extent and how effectively banks have used CLS to reduce their foreign exchange
settlement risk exposures and whether or not there was potential to further reduce
settlement risk by using CLS. Second, the task force was to explore, if in the course of
reducing settlement risk by using CLS, whether other risks, such as operational or
liquidity, had been introduced into the payments environment.
The task force reviewed possible approaches to drafting the survey, including
dissemination of a quantitative-based survey approach similar to the one originally used
to gather data in support of the 1996 and 1998 reports issued by the Committee on
Payment and Settlement Systems of the Bank for International Settlements. While
members agreed this approach would provide significant quantitative data, members were
concerned that the work load associated with completing this type of survey would be
overly burdensome to the participating institutions especially since they were already
involved in compiling data for the Triennial Survey. As a result, the task force members
opted to draft a more qualitative survey which could be augmented by certain generic
quantitative data furnished by CLS. Once the survey was in draft form, the task force
also consulted with the Operations Managers Working Group of the Foreign Exchange
Committee to solicit their buy-in and cooperation.
The task force elected to focus on four main areas and allow a fifth section for open
ended discussion of any topics participants felt had not been adequately addressed in the
survey document. The task force further determined that only those institutions
represented on the Payments Risk Committee would be requested to complete the survey.
4. SURVEY RESULTS
4.1 OVERVIEW
The task force concentrated on utilization of the CLS system by the participants, changes
in measurement of credit risk since the inception of CLS, changes in intraday liquidity
patterns and management thereof, and the operational impact of CLS. Additionally,
5
participants were encouraged to provide additional commentary on any aspect of CLS
which may have created additional risk or cause for concern. The survey was returned to
the Federal Reserve Bank of New York in order to ensure confidentiality of proprietary
data. The data was then compiled and preliminary analysis shared with the task force.
All nine of the institutions which participate in the PRC responded although given that
one member was still in testing its responses were limited by its lack of a live
implementation. The task force reviewed the preliminary analysis and a discussion on
each of the findings follows.
4.2 DISCUSSION OF SURVEY FINDINGS
4.2.1 Participation
Each of the respondent institutions is participating in CLS and all but one is a settlement
member. There was no discussion relative to the non-settlement member’s decision to
participate in CLS as a third party.
While each respondent is participating in CLS, the value and volume of the foreign
exchange trades settling through CLS varies significantly. Only one institution indicated
it is submitting all of its eligible foreign exchange trades to CLS including those done
between the institution’s own branches. Of the remaining institutions, approximately 40
branches across all seven institutions are participating in CLS. The primary reasons for
branches not submitting to CLS are insufficient volumes in the branch to justify the
required infrastructure and procedural changes, the ineligibility of same day trades, and
competing priorities with other bank initiatives.
In terms of the value of the trades being submitted, the majority of institutions were
submitting in excess of 25% of the gross value of their eligible trades while three
institutions were above the 75% value including the one institution that submits all of its
eligible deals to CLS.
The respondents had mixed experiences with regard to increased trading values since
CLS began operations, with more than half reporting no change and the remaining
reporting an increase. Only one institution believed the increase was due to the
introduction of CLS while the others cited more favorable business conditions.
Many of the institutions have actively pursued offering third and fourth party services to
their customer base. Some are experiencing 50% of their third party clients’ activity
settling in CLS and there is a major push by these institutions to build on this in the near
term. There was some discussion that third party activity has allowed some institutions
to meet their committed volumes to CLS even though their own branches are not fully
participating in CLS.
The task force spent a good deal of time discussing the somewhat limited participation in
the CLS process by many of the respondents and the reasons given, including the
inability to include same day trades, counterparties not being CLS participants,
insufficient volumes to justify the changes required, minimal incentive for the front
office, and minimal direct pressure on the part of the regulators. Given the time and
resources devoted to the implementation of CLS and the fact that it has become the
industry standard for settlement of foreign exchange items, the task force believes that
6
financial institutions need to be more aggressive in submitting all of their eligible activity
to CLS.
4.2.2 Credit
In general, the respondents indicated a decrease in the overall settlement risk for their
respective institutions as a result of the CLS process although for those offering
third/fourth party services they also noted related increases in certain intraday exposures.
The respondents were also split on the measurement of credit limits for trades settling in
CLS. More than half of the institutions responding indicated that they no longer calculate
settlement risk for trades settling in CLS although they do maintain a settlement line for
each counterparty to accommodate trades that settle outside of CLS. Those institutions
continuing to calculate settlement risk on CLS settled trades do so because of system
constraints or because the counterparty retains the ability to unilaterally rescind trades
leaving them subject to traditional settlement methods.
Most of the institutions participating in the survey also participate in the in/out swap
process and maintain settlement lines for these trades. While the institutions
acknowledge that the in/out swap process reintroduces settlement risk, most reported that
it is less than 10% and is manageable.
Those institutions offering third/fourth party services are selective about their client base,
have implemented controls to limit the amount of risk they assume on behalf of the client
and have also implemented intraday caps to control their CLS exposure. There was a
good deal of discussion relative to the increase in intraday exposure as a result of this
activity.
There were two other areas that the task force reviewed relative to credit exposure, one
relating to non-CLS settled trades and the other relating to netting arrangements. In
general, participants acknowledged that there are dedicated, hard settlement limits in
place for non-CLS settled trades and the criteria used is similar to that used for other
extensions of credit. Most of the institutions are measuring the lines on a daily basis
although a couple noted that they use a time-line methodology and two are planning to
migrate to a time-line basis in the future.
As there are numerous currencies not eligible for CLS settlement, most of the participant
institutions continue to utilize a bilateral netting process to minimize their exposure.
However, they also indicated that there are inherent operational difficulties associated
with the netting process. Further, there was no consensus on development of netting
capabilities within CLS or reintroducing another utility to accommodate netting of non-
CLS currencies.
4.2.3 Liquidity
In reviewing the survey results, the task force noted that the CLS process has had a
significant impact on the management of intraday liquidity by virtue of the requirement
for timed payments and the availability of liquidity to effect the payments. While gross
payouts and receipts are substantially lower, the individual payins and payouts are
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generally larger and time critical. Notwithstanding these changes, respondents agreed that
liquidity risks were manageable.
It was noted that most of the respondents are clearing only a few currencies themselves
and utilize a nostro agent to make their other payments. The two most frequently selfcleared
currencies are the USD and the Euro. In discussing the timed payments, task
force members noted that there are increased costs as a result of the use of intraday credit
at a nostro, increased debit cap usage, or pledged collateral.
The respondent settlement members are all utilizing the in/out swap process to reduce
their liquidity needs and have found it to be effective and the risks manageable. Its
discontinuance would increase their liquidity risks. Most of the respondents indicated
that the in/out swap frequently brings them to the trade-down limits.
Respondents were mixed with regard to the other risks associated with making the timed
payments although they were in agreement that the risks were manageable. Most of the
respondents indicated that they had experienced late pay-ins with the primary reason for
the failure being a systems issue although communications and operations were also
cited.
Not all respondents have had a positive experience in all of the currencies but the
problems are somewhat isolated. Further, there is no consensus on liquidity constraints
as additional currencies are introduced with half indicating that they will experience more
pressure while the other half indicate they expect no change.
Most respondents indicated their institutions would benefit from an intraday liquidity
market; however, they are not currently using any other liquidity tool to manage their
positions.
4.2.4 Operational Impact
The survey indicated some improvements on the operational side particularly with regard
to reconciliations, decreases in investigations, and decreases in losses associated with
foreign exchange trades. There was no indication that there were corresponding staff
reductions as a result of these operational efficiencies.
In fact, most respondents indicated that they have either extended hours or increased staff
to accommodate the CLS process. Business continuity was also factored in and a number
of institutions utilize multiple branches to perform control branch functions. The model
appears to be that one site has primary responsibility with the others serving in a
contingency capacity. There was no discussion on a follow the sun approach.
Other efficiencies include improvements in straight through processing and the
elimination of the MT 300 confirm. Most institutions also reported a decrease in
payment activity as a result of CLS with six institutions reporting a decrease of over 10%.
There does not seem to be any significant change in the timing of the overall flow of
payments.
The survey found that this set of respondents finds the CLS eco-system to be resilient and
reliable although there are components which on occasion give rise to operational
problems. The survey found that these members are well versed in the best practices
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relative to handling trades in terms of outages and can accommodate the practices.
Additionally, it was noted that CLS has been responsive to the interagency white paper
on business resiliency and members are generally comfortable with the actions taken to
address business continuity; however, all of the institutions expressed concern about any
potential extended CLS outage in the event of catastrophic failure citing liquidity,
communications, and back office processing issues as key factors. The members also
noted that the new environment has real time linkages for all of the participating RTGS
systems thereby creating increased interdependencies. Consequently, outages in any
RTGS have a significant impact on each of the participating institutions relative to
operations and liquidity.
The survey requested feedback on vendor concentration risk. While the group
acknowledges that the number of suppliers is small and there is a risk that any of the
suppliers could exit the business or could have software defects that create havoc within
the CLS eco-system, the members were evenly divided on this issue as to the magnitude
of the risk and what could be done about it from an industry perspective.
5. CONCLUSIONS AND RECOMMENDATIONS
The task force believes that the CLS system has been effective in reducing settlement risk
in the foreign exchange arena. That effectiveness has been somewhat diminished by the
lack of full participation in the process both by its own members and by a number of
significant counterparties who have not yet subscribed to the CLS process. Task force
members indicated their institutions were in various stages of ramp up at the time of the
survey and progress is ongoing at a number of institutions. CLS’s own data reflects the
continued buildup in both value and volume by these institutions. However, a number of
large counterparties have yet to subscribe to the CLS process either as a settlement
member, user member, or third party.
The task force would like to see increased participation of counterparties by encouraging
them to bring their non-CLS trades into the CLS process. However, respondent
institutions indicate that there may exist a set of non-CLS settled trades (including
proprietary trades and those for corporate and other customers) that may not pose a
significant settlement risk, for example, trades that are settled "on us" or those that are
bilaterally netted. The members felt that bringing such trades into CLS may not be
feasible or warranted, particularly if institutions are able to recognize, manage and
control their exposure in settling those trades. However, verifying that the associated
settlement risks with these trades are well managed may require central banks to conduct
a more in-depth and confidential analysis to assess an institution's effectiveness relative
to the nature, size, duration and concentration of these exposures.
Nevertheless, the task force believes there is a significant set of trades that, from a safety
and efficiency perspective, could and should be settled through CLS. To this end, the task
force believes there are other factors that can significantly improve counterparty
participation in the CLS process. The current ineligibility of same-day trades acts as a
potential obstacle for transactions to settle through CLS. The task force favors CLS
exploring the significance and possibility of additional settlement cycles to bring these
trades into CLS. Another recommendation of the task force is to ensure that front offices
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are completely engaged in the CLS process. It is essential that traders are fully aware of
and internalize the benefits (operational efficiencies) and the risk reduction that results
from trading with CLS counterparties. There is a need to develop appropriate incentive
structures to encourage the front office to settle trades through CLS (e.g., through pricing,
fees, trading limits or other ways to differentiate between trades settling inside or outside
CLS).
The members contemplated the effectiveness of individually and collectively pursuing
these measures to increase use of CLS. Regulatory support, and possibly pressure, may
also be needed to encourage progress.
The task force believes that CLS is a positive and productive process and stands as a
testament to the private sector’s ability to address and mitigate risk issues. It has resulted
in a number of operational efficiencies, such as the elimination of the MT 300 and
improvements in the reconciliation process. Members are also encouraged by the
reduction in losses as a result of the CLS process. While the task force identified some
increased risks, those risks have been manageable. The only risk that remains of concern
is liquidity and the downstream impact of increased intraday costs associated with
making timed payments when funds are in limited supply and there are competing
priorities for them. The participants acknowledged frequent use of the debit cap in the
early morning hours in order to fund the CLS payments. While liquidity risk currently
appears manageable, the task force believes there should be additional focus on
monitoring the evolution of this risk over time for signs of potential pressure on intraday
liquidity.
It should be noted that this survey was very limited in nature and the findings presented
here may not be indicative of the total CLS experience. The task force believes it would
be useful for regulators or other private sector risk committees in non-US locations to
perform a similar exercise, the results of which could be shared, to gain a more
comprehensive view on this topic.
source: www.newyorkfed.org/prc/fxsettlementrisk.pdf