Settlement settled?

The collapse of Lehman Brothers and other banks last year proved that settlement risk in the forex market has been greatly reduced. But while forex operational risk managers may be giving themselves a pat on the back, there are warnings that settlement risk needs to be cut back further. By John Ferry

Last year was the biggest test yet for the foreign exchange settlement system known as CLS Bank, an industry-wide private initiative launched in 2002 that works to remove settlement risk in forex deals. Since it launched, CLS Bank has seen a steady rise in the number of trades it handles, and today settles the majority of interbank foreign exchange deals. This proved to be a major boon when Lehman Brothers collapsed on September 15 and traders across the world simultaneously scrambled to unwind positions and figure out how their trading books would be affected. The result was operational systems being stretched to the limit. However, thanks to the industry's efforts to address settlement, no significant losses were reported due to this particular type of risk in foreign exchange.

"There was no significant system downtime during the challenges of last year, so CLS stood up well from that perspective," says Jeremy Hill, head of foreign exchange, forex options and money market operations at Royal Bank of Scotland (RBS) in London.

"The Wednesday of the week when Lehman collapsed, we posted a new record for the volume of payment instructions settled in one day (1,554,166 payment instructions with a gross value of $8.6 trillion) because it was also one of the quarterly rollover dates for the derivatives market, and there are a large amount of forex trades attached to those cycles. But it all went exactly according to plan. Everybody executed and settlement completed as per normal," adds Jonathan Butterfield, director of communications at CLS Group, the parent holding company for CLS Bank.

Settlement risk reflects the danger that one party to a forex trade pays out the currency it sold but does not receive the currency it purchased. It comprises both liquidity risk (the risk the purchased currency is not delivered when it is due) and credit risk (the risk the counterparty defaults and never pays).

If the bank collapses of 2008 had occurred 10 years ago, settlement risk could have had a huge systemic impact. Back then, foreign exchange settlement exposures were in many cases exceedingly large relative to bank capital, the exposures lasted overnight or longer, and were poorly understood by senior management. Indeed, the Bank for International Settlements (BIS) estimated that 85% of forex settlement obligations in 1997 were settled by traditional correspondent banking, in which the value of each side of the trade is transferred between the counterparties independently. "If you go back 15 or 20 years ago, foreign exchange settlement risk was one of the biggest areas of risk in the market," says London-based Faizul Mohamed, a manager at OpenLink, a technology provider.

Given the fact settlement risk wasn't an issue in September and October, it might be tempting to think the foreign exchange market has reached a kind of end-game in tackling this issue. Not according to the BIS. The group's position has not changed since last year, when it called for more action to reduce settlement risk in the foreign exchange markets. The report, published in May 2008 and written by the Committee on Payment and Settlement Systems (CPSS), a forum of central banks that was chaired by then-president of the Federal Reserve Bank of New York Timothy Geithner, recognised that significant progress had been made in addressing the issue. However, it warned that more should be done to tackle remaining exposures that could present systemic risk, and to avoid the risk of reversing the progress that has been achieved. The question is: how?

The first major industry-wide initiative to address the issue came in 1996, when the G-10 central banks endorsed a long-term strategy to reduce the systemic risk that arose from the way forex trades were settled. This followed a study of the foreign exchange market, which found forex settlement exposures tended to be underestimated by banks, while risk management measures were often inadequate. In response, the BIS instructed banks to control their foreign exchange settlement exposures, and encouraged the industry to establish risk-reducing multi-currency services - a call to arms that resulted in the setting up of CLS Bank.

"We were established as a result of very significant regulatory pressure and an explicitly stated comment that if the industry doesn't deal with settlement risk, then the regulators would do it for them. Nobody knew what that meant, but it could have been some form of margin or capital allocation that would have made the industry considerably less profitable," says Butterfield.

CLS was launched in 2002, and works by providing a 'payment-versus-payment' service that virtually eliminates the settlement risk by ensuring currencies are transferred simultaneously (see box).

More than 10 years on from the CPSS's original study, it published another report on the progress made in eliminating the problem last May. The survey was conducted by 27 central banks and involved 109 institutions covering 80% of the forex market in 15 currencies. The trading firms that took part reported average daily forex settlement obligations in April 2006 that had a gross value of $3.8 trillion.

The study found that 55% - or $2.1 trillion - of surveyed obligations were settled through CLS Bank. However, 32% of obligations were settled through traditional correspondent banking arrangements and so were subject to settlement risk. Half of these obligations were at risk overnight and not just intra-day. The CPSS also reported that some bilateral settlement exposures were large relative to capital and not well controlled, with 63% of surveyed companies underestimating their bilateral foreign exchange settlement exposures.

Perhaps more worrying, the CPSS concluded there is a potential risk of backsliding. While most of the surveyed companies had broad internal policies that favour the use of risk-reducing settlement methods, many institutions use incomplete risk measurements and cost-benefit calculations that can "prevent fully informed and appropriate choices among forex settlement methods", the CPSS warned. It added this increases the potential for firms to consider less safe settlement methods, especially when faced with changing trade patterns and cost pressures.

However, Butterfield says these figures exaggerate the amount of settlement risk prevalent in the system. He argues that a significant proportion of trades that banks conduct with clients are book-settled by the bank. Take, for example, a corporate executing a forex trade with its main cash management bank. The cash management group would debit or credit the corporate's account and the relevant change would be made to the trading book - meaning the money never actually leaves the bank. As all the accounts are held at the same firm, the deal is arguably not subject to settlement risk. "Our view from talking to our banks is transactions that are book-settled account for somewhere around 30% of their forex trading. Add that 30% to the 55% of trades settled through CLS, and the gap that is not yet settling in CLS is significantly lower," says Butterfield.

Still, Butterfield and other industry participants agree in principle with the CPSS that more could be done to further address and reduce settlement risk. The regulators suggest action should be taken by individual institutions - for instance, firms could shorten the duration of settlement exposures by modifying internal payment practices and corresponding banking arrangements to eliminate early payment cancellation deadlines, while all institutions should take steps to avoid underestimating the risk they incur intra-day and overnight given the size and duration of their remaining settlement exposures.

The CPSS also recommends further development of forex settlement services. One obvious way to do this is to expand the number of users of CLS. RBS's Hill represents his bank on a forex joint standing committee of major interdealer counterparties, which met in January to discuss what aspects of CLS could be changed or improved in order to get more business through it. "There is now more focus on trying to get more currencies on CLS and trying to get more participants using it, either as direct settlement members or as third-party settlement members," he says.

In August 2008, CLS Bank added the Israeli shekel and the Mexican peso to its list of currencies, bringing the total covered to 17 (the rest are the US, Australian, Canadian, New Zealand, Singapore and Hong Kong dollars, euro, sterling, yen, Danish and Norwegian krone, Swedish krona, Korean won, South African rand and Swiss franc). Emerging market currencies such as the Brazilian real, Turkish lira, Russian rouble and Chinese renminbi would seem like obvious candidates for future inclusion - although CLS Bank is giving nothing away when it comes to which currencies it may be considering trying to integrate.

However, getting a new currency on board is not a simple process. CLS has to connect seamlessly with the real-time gross settlement systems in the countries of each of the currencies it handles, as well as with the Swift interbank messaging network and all participating banks. Any new currency has to be liquid and the full participation of the central bank of the country involved is also needed.

The other way CLS can expand is to increase its user base in the currencies it already operates in. Butterfield says getting institutional investors and corporates - which can access the system via a third-party bank member - to use CLS is a priority. "We have doubled the number of funds that participated last year and we continue to add more," he says.

One potential drag on future expansion - and one of the criticisms of CLS - is the cost of using the service. CLS charges a fixed cost per ticket, and although this has come down over the years, the downside is that it fails to allow for costs to be reduced through netting. "If you do 100 trades with a counterparty, then you're not able to bring them to CLS netted down into a single small ticket," says Mark Warms, London-based European managing director of FXall, the forex trading platform.

"That has pushed people to either settle outside CLS or to look for solutions that are not quite as robust as CLS, either from a technical standpoint or from a standpoint of working with central banks or regulators," adds Neil Penney, FXall's global head of product strategy.

All Butterfield will say is that this is an issue CLS members are working on. "We charge per transaction with a lower price for lower-value deals. This model is under review with our banks and an alternative is likely to be launched later this year," he says.

Another way to extend the scope of CLS would be to allow for settlement of intra-day trades. Again, this is something CLS Bank is looking to take action on. "This has been a matter of discussion and analysis for some time," says Butterfield. He adds there is tension between running a second settlement cycle and the extra liquidity management pressures this would exert. But CLS Bank is working with its members to establish a later, second settlement cycle in North America.

The CPSS also states that individual institutions should encourage their counterparties to use CLS or any other payment-versus-payment arrangement, as well as consider using bilateral netting to reduce settlement exposures.

However, some market participants question the benefits of expending time, money and resources to try to reduce forex settlement risk when so many other parts of the financial system have broken down. "The level of transparency in the foreign exchange market and the way it operates tends to show it is more resilient than other markets, and in the current situation I think priorities should be defined first, to see where most of the danger is. There should be more concern with the credit default swaps market," says Axel Pierron, Paris-based senior vice-president at consultancy firm Celent.

"Foreign exchange is not a highly leveraged business, unlike some of the derivatives markets, so I think it is inherently less risky," adds Penney of FXall.

As banks around the world rush to deleverage their businesses and raise capital levels, all the while struggling with continued writedowns, some would argue trying to reduce forex settlement risk in the current environment amounts to a complete misuse of scarce resources. Why focus on a risk that did not lead to systemic worries last year when there are so many others out there that did?

But then again, if recent history tells us anything, it is that we can't know where the next crisis will come from. "The flipside is it needs just one story on the front page of the Wall Street Journal or the Financial Times on foreign exchange and people will see the market radically differently. So we have to be on top of, and be prepared for, any development that happens," says Penney.

HOW CLS BANK OPERATES

Each CLS member bank (CLS Bank reports there are 60 CLS members and 4,154 participants) holds an account with CLS Bank, and a trade is settled on the accounts of the two relevant members by simultaneously debiting the accounts by the amount of the currency being sold and crediting them by the amount of the currency being bought (payment-versus-payment). Settlement only takes place if both parties meet the platform's risk controls, which includes retaining an overall positive balance on their accounts.

CLS Bank collects trade data from its members continuously and runs its payment-versus-payment settlement cycle once a day.

If a member fails to pay an obligation, CLS Bank can return to the counterparty the value of the currency it is selling. In addition, it also reduces liquidity risk because CLS is designed to have standing liquidity facilities with large banks, so it can, in effect, convert the currency the counterparty is selling into the one it is trying to buy should there be a failure to pay. So, as a last resort, it effectively becomes a dealer to ensure the trade gets done - although this liquidity management function is limited, as the liquidity facilities are finite.

By September last year, CLS Bank was settling an average daily volume of more than 700,000 instructions, with a gross value of more than $4 trillion.