Unlike other asset classes, the settlement mechanisms in the foreign exchange market appear to have worked well, even when market turmoil was at its height late last year. Risk and roundtable partners CLS, Citi, Credit Suisse, Deutsche Bank and HSBC convened last month to discuss where improvements are still needed
Risk: Is settlement risk less of an issue for the market now?
Joe Norena, HSBC (JN): We haven’t solved the issue completely but we have mitigated a core part of it, particularly the large flows between the interbank players. The main area where settlement risk remains is between the buy side and the sell side.
Andrew Coyne, Citi (AC): The continuous linked settlement (CLS) mechanism worked extremely well at the height of the crisis. Clients have been focusing on their bank relationships and now we have to turn to increasing the degree of payment versus payment that can be achieved in the overall market.
Peter Connor, Deutsche Bank (PC): The Lehman Brothers default proved the interbank foreign exchange (FX) market still functions, even during periods of high turmoil. But there are weaknesses related to smaller emerging market currencies and second-tier banks. The drive to join the CLS system in some jurisdictions has been poor, but that dynamic is changing. Institutions now realise the importance of CLS in ensuring they can access FX products from the interbank market at all times.
Risk: Rachael, have you seen a significant increase in firms signing up to CLS?
Rachael Hoey, CLS (RH): Approximately 75% of eligible trades are settled on CLS. The figure is not higher because there are still a few counterparties who are able to but are not using the system, and because there is room to expand the number of eligible currencies from the current total of 17.
As far as how the system has held up, in the week of the Lehman collapse we settled over 150 billion of Lehman’s trades and across the week the community settled 26 trillion. So CLS, which uses a payment-versus-payment system, worked effectively for the market. People understand how well the FX community worked and realise that using CLS is where the greatest risk mitigation can occur. From October last year to October this year, our third-party membership doubled, from over 3,000 entities to more than 6,000 entities, mostly due to funds – especially long-money funds – becoming members. We have also seen expanded bank membership from jurisdictions in which we did not have much penetration before.
But the work is not over. The currency programme will continue to expand. We are working with the UK’s FX Joint Standing Committee (JSC) and the FX Committee (FXC) in the US to look at all of the counterparties banks are actively working with but are not using CLS. We have a list of over 150 counterparties and are working with banks to bring those on board.
PC: There is a real focus on risk management in the industry by all participants. We have seen a drive from the buy side to use CLS as they assess the risks they face with their FX activities. The push-pull dynamic is working much better now that investors want to mitigate their risk as well as banks.
Risk: Historically, the process of getting third parties on board has been slow. Is there anything the industry and CLS can do to speed up the process?
Martin Wiedmann, Credit Suisse (MW): The regulators should be extremely pleased with how well the FX markets functioned during the biggest crisis in history. Without CLS, the growth we have seen would not have been possible: to trade $3.3 trillion a day without CLS would not be possible. We should all be relieved that such a big uptake is now taking place to make the cleared volume go even higher.
JN: It is not only settlement risk where the industry is co-operating, but also in addressing credit risk and operational risk. Standardising documentation is just one example of how the industry is working together.
AC: There is a slightly asymmetrical relationship between the large banks that are CLS members and the smaller banks that we give clean credit to: clearly it’s in our interests to make sure they are members. We have to offer more third-party services and make sure third-party providers compete to expand the availability of that service.
MW: I’m surprised two-tier pricing has never been established for non-CLS settled trades. If there was a tax on those trades, it would incentivise people to join the CLS system.
Risk: Do you see the market moving towards a two-tier pricing system?
MW: Perhaps it won’t happen in the spot market but, with longer- dated and lower-rated corporate names, some credit charge could be applied.
AC: When a spot trader is closing a trade he’s not sitting there thinking ‘this counterparty isn’t on CLS’, so he should quote a wider price. It’s a very competitive market and you would lose the trade because there are other firms willing to offer tight prices that may not be on CLS. It’s difficult to bring in a charge for a counterparty that is perceived to be slightly riskier just because they aren’t part of that service.
JN: When the markets are operating efficiently and there is ample liquidity, there aren’t the systems out there that can, in real time, let traders know what the credit risk is and price it accordingly. However, once there are liquidity concerns and uncertainty, the spot market adjusts very quickly.
RH: It is during real-market events that spreads will widen. Banks and market participants address counterparty risk and other risks in different ways. Some initiatives are binary: if you are going to trade, you make sure the Credit Support Annex (CSA) is in place and you have the right collateral arrangements. Now we are also seeing firms requiring that trades must be settled in CLS as part of the overall risk mitigation package.
The other thing the market has done post-Lehman is look at trading lines and tightened the protection around counterparty risk. From an operational risk perspective, institutions are focused on whether counterparties have straight-through processing (STP) in place. The market is really looking at the cost of liquidity; in many respects, the issue is not necessarily about pricing on the spot but the liquidity implications and how they should be priced into a trade.
PC: The primary liquidity providers have assessed the settlement lines they have to second-tier banks that are not CLS members. In many instances they have reduced their exposure to these names. And, as those second-tier names find their access to liquidity restricted, joining CLS will be seen as a must-have if they want to participate in the interbank market.
RH: When CLS first saw a lot of buy side and corporates coming on board, those entities found their lines with banks expanded because they were settling in CLS. Since the crisis, this has become even more prevalent. The long-money funds actively trading, including the currency hedging funds, have seen this happen. The benefits of membership are not just about STP efficiencies, it’s also about access to liquidity and the ability to trade.
Risk: You’ve mentioned the effort to get more second-tier banks on board. Is there also an active programme for increasing end-user membership?
AC: We combine CLS third-party services and prime brokerage to enable clients to reduce their overall exposures; not just settlement exposures, but also netting transactions down to single payments and concentrating their credit to reduce the mark-to-market on a multilateral basis. More banks will look to that model: prime brokerage will cover the non-CLS currencies and prime brokers are very much focused on providing clients with technology solutions for allocations and real-time mark-to-market valuations. Combining those services gives clients a one-stop shop to manage their portfolios.
Risk: Peter, what is the approach at Deutsche?
PC: Traditionally, the CLS third-party offering has been sold out of our commercial bank. So it is packaged together with the way in which the bank sells cash management services as opposed to being sold out of FX. But there is a strong partnership between both parts of the bank to deliver this service. The pipeline we have in terms of on-boarding third-parties onto CLS has never been longer and we are putting in more resources to speed up this process.
Risk: Martin, is that a similar experience you’ve had at your bank – there’s a huge pipeline for third-party sign-ups?
MW: There is a joint effort between the business side and the payment and clearing system to onboard clients onto CLS, as well as getting International Swaps and Derivatives Association master agreements signed and CSAs in place. CLS plays an important role so there is a push from various parts of the bank to onboard more third parties.
Risk: An obvious next step will to be to include more currencies in the CLS system. How was the experience post-Lehman of those currencies within CLS and those outside of the system, as well as some of the difficulties surrounding the emerging market currencies during that period?
JN: I was actually working in the buy side at the time, but my understanding is that the market performed very efficiently during this period. Both the FXC and JSC issued papers that highlighted to regulators how well the FX market held up; not just the core G-10 currencies but also the emerging market currencies.
MW: The big exception was the Icelandic krona, which was not part of CLS. That was a lesson for all of us. There were a huge number of crisis calls and conference calls when that situation was happening; no one really knew whether certain trades would settle or not. So that certainly raised questions about non-CLS currencies.
PC: We can talk about liquidity in the spot market but the real issues occur around the funding side of a currency. During the crisis we saw a reluctance to use the FX forwards market to fund positions in a currency. It was definitely the case in the forwards market that, if the currency wasn’t settled on CLS, the risk was priced in or the trade was not done at all. The push to get more currencies on the system is absolutely key.
Risk: Rachael, could you give an overview of where things currently stand in terms of widening the universe of currencies?
RH: Expanding the number of currencies in CLS is a priority, but you have to ensure you do not introduce systemic risk by introducing either new participants who don’t meet the thresholds or the currencies themselves. The most recent additions were the Israeli shekel and the Mexican peso, and we are now looking at three currencies coming in over the next 18 months to two years. Over the next three to five years we might also see some of the BRIC (Brazil, Russia, India, China) currencies come on board. It can be a protracted process because we have to look at the rule of law in a particular country to make sure the courts work effectively, and also whether legislation needs to be passed.
With the Israeli shekel, we had to get legislation passed through the Knesset [the country’s legislative system] to underpin what we needed in terms of protecting the system and the certainty of settlement. In the event of a crisis or a bankruptcy, people need to know that in any given country the money will be where the system expects it to be. Additionally, we need to consider the convertibility of the currency. We actually went live with the Korean won when currency controls were still in place, which showed controls can be present as long as the market has some ability to move funds.
In Mexico, we worked hard at getting standardisation for some of the payment remittances. One of the reasons CLS and the FX market works so well is because we set global standards. The challenges we face concern aligning these requirements. There is a lot of co-operation with local banks, who become settlement members and then nostro providers to the rest of the community in order to bring that country up to global standards. CLS is accountable for standards as well as being regulated by the Federal Reserve, we are held accountable by an oversight committee of more than 20 central banks to ensure systemic risk is managed and new currencies meet those thresholds.
Risk: Would the drive to add new currencies and members be helped by a greater regulatory push?
PC: If regulators can assist in getting more participants into the system it would be extremely valuable.
MW: The FX market has always been self-regulated, and has proven during times of extreme stress to be an asset class that can still function well. Perhaps other products and markets would benefit from and need that regulatory pressure more than the FX market does.
Risk: There has been a lot of discussion on central clearing, including clearing of FX contracts. Would the market be better served by focusing less on central clearing and more on settlement risk?
AC: FX is a very complex market with a number of distinct participants. CLS clearly addresses the majority of settlement that happens on a daily basis: a central counterparty (CCP) clearing model isn’t particularly necessary, but there are some client segments that may have a futures bias. They may be used to that form of placing collateral and clearing trades, and potentially might be interested in processing FX trades in a similar way. Different client segments may look for different solutions. Corporates, for example, are dependent on bank relationships for different services. It would be difficult to enforce a single solution on a complex market because the end-users have different needs. Martin mentioned we are self-regulated; if any pressure does come from regulators to get more participation in these types of solutions, it might be placed on the major banks to differentiate how they give clients access to the market to force all participants into some form of secure clearing or settlement system.
JN: The one thing I would add is that there are different price points, depending on the activity of a client. Some clients are used to futures transactions and posting margin, whereas for other clients – because of the magnitude of their activity in the FX market – to post any kind of margin into a central clearing house would be at a much different price point than a mechanism like CLS.
PC: FX is principally a physically delivered product. The issues around CCPs and settlement risk are for a separate discussion. The groups who aren’t active in CLS trade FX as part of their overall portfolio. Corporates have strong relationships with their banks and conduct FX trades through their core bank. They want that bank to provide credit and facilitate the settlement of the product on their behalf. It is going to be extremely difficult to persuade corporates to join CLS.
On the flip side, if we look through the crisis and what happened with some corporates, banks have alternate mechanisms to manage settlement risk. CLS is absolutely key in maintaining the operation of the market as a whole, but in terms of physical delivery there are other mechanisms that help mitigate risk.
RH: If a firm wants to cut counterparty risk, going to a clearing house mutualises it. But many of the relationships a bank has with its clients are strong – they do want that counterparty risk. Additionally, although clearing mitigates counterparty risk, it does not mitigate settlement risk. If you look at some of the draft legislation coming out of the US, it says that utilities doing clearing should also look at safe settlement mechanisms. The descriptions of safe settlement mechanisms resemble the model of CLS. FX is the only asset class where there is cash on both sides and that is where the payment-versus-payment model has benefits in respect to settlement risk mitigation. CLS settles for clearing houses in the credit derivatives markets, so there is a precedent of clearing houses that manage settlement risk mitigation through CLS.
MW: Who is to say a CCP will not increase systematic risk – is there any CCP strong enough to take the operational risks on itself and ensure the system will always function? It probably adds to systematic risk, rather than reduces it. Around 90% of the risk in the FX market is settlement risk and 10% is pre-settlement market risk. We are dealing well with the biggest risk and the industry has always known how to handle the smaller,
pre-settlement risk. Enforcing the use of CCPs would place a huge burden on corporates to fund pre-settlement and come up with the margin requirements.
AC: We deal with sovereign currencies so it would be difficult for any one regulator to impose a set of rules on a global basis. The risk of a single solution for the whole market is that it will concentrate risk. It also kills competition, but we already compete very effectively for different services, whether it’s securing clients’ collateral, providing credit or giving people access to the marketplace. We are going about things the
right way when it comes to providing solutions to different market participants.
Risk: Is there anything banks can do internally to eliminate settlement risk that goes between client accounts or between different subsidiaries within their own institution?
PC: Banks are starting to package FX services with cash management services. By doing that, the settlement risk between the bank and the client account is contained within the same organisation. Banks can look to reduce their settlement risk with names they’re less comfortable with by saying ‘if you want to trade FX with Deutsche Bank, for example, we’d like you to settle with us as well’.
Risk: The FX JSC report makes reference to aggregation services and netting. What is the status of other initiatives the industry is working on?
MW: For retail aggregators who do thousands of tickets a day, it is essential to aggregate that risk into much fewer transactions. Firstly, aggregation will help reduce the risk and it will also reduce the workload on the banks’ systems and operations. The joint venture between CLS and ICAP Traiana will allow us to continue to grow the business overall at a much reduced cost.
RH: The joint venture offers the market an operational risk reduction mechanism for high-frequency and high-volume trading. It carries out central matching and compressing of trades so that less trades have to go through back-office systems to reduce operational risk. We’ll be going live with a number of banks active in the high-frequency trading business to deliver that service. The trades that come to CLS for settlement, together with the trades that will be going through aggregation, will all be in our trade repository, which represents around 75% of the market. Eight founder banks are joining and we expect to extend that over a period of time.
PC: Throughout the history of the FX market, banks have worked hard on a bilateral basis to address operational risk. There have been a huge number of initiatives, including increasing STP rates, standardised documentation and managing huge volumes. The industry is starting to look for more centralised solutions and aggregation is a good first step in building tools that will help all market participants mitigate operational risk. Once aggregation is achieved, I am sure there will be a new idea to mitigate risk somewhere else in the system that will come from this
Risk: In summing up, is it fair to say the industry is pleased with the way the market performed during the post-Lehman fallout last year, but recognises more work needs to be done?
AC: The FX markets performed well throughout the crisis. The mechanisms in place, in particular CLS, passed the test. Now we need to think about preparing for the next crisis, which history suggests will be different in nature. We need to work out how best to get more counterparties onto CLS, increase the number of currencies, and also look at how we can effectively compete to provide better and more cost-effective services to a diverse client base. Initiatives such as CLS aggregation will help us move in that direction and offer more ideas about how we should manage credit, settlement and operational risks.
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