CLS on defensive over lack of central clearing

The Continuous-Linked Settlement (CLS) Group, the London-based organisation that runs the global system to reduce foreign exchange transaction risk, has been forced to defend itself against accusations that it should have been set up as a fully centralised clearing facility, rather than a system designed just to eliminate ‘Herstatt risk’.

In a briefing to journalists in London last month, senior bankers at Dresdner Kleinwort Wasserstein (DrKW), criticised CLS – and the banks involved in setting it up, which include Dresdner – for not going far enough in addressing the risks associated with trading foreign exchange.

Alex Wilkinson, global head of DrKW’s listed products group, said that when regulators pushed the world’s biggest banks to come up with a system to get rid of Herstatt risk – the risk that time-zone differences could lead to one party to a trade defaulting before it has paid out on its side of a forex contract – the banks involved “all got on the bandwagon”, without looking at what they would get for their money.

“They [CLS management] have not fully concluded what they need to, which is to bring foreign exchange into a fully cleared environment,” said Wilkinson. “The foreign exchange market is crying out for proper central counterparty clearing.”

Unlike other markets, such as equities, there is no central clearing facility for over-the-counter foreign exchange trades. Central clearing organisations such as EquityClear, which services UK and Irish equity deals, guarantee trades by acting as the counterparty on both sides of a transaction.

As well-capitalised organisations, they lower the average credit risk associated with a trade. They also allow for anonymous trading regardless of the capital position of a market participant. Dealers say centralised clearing facilities ultimately enhance market liquidity while reducing regulatory capital requirements for trading institutions.

CLS, which was launched in September 2002, is designed to settle trades on a net-funded basis over a period of time when country-specific real-time global settlement systems overlap.

Jonathan Butterfield, executive vice-president in charge of marketing and business development at CLS Group, responds that it was the banks involved in coming up with a system to eliminate Herstatt risk that opted not to create a centralised clearing facility.

“It was an industry choice rather than ours,” says Butterfield. “There’s often an assumption that because we’re a separate entity we came up with this. The actual process that was undertaken that preceded any entity called CLS was actually very much an industry dialogue,” he says, adding that a central counterparty model was considered but “gained minimal support from the other participants”.

“The view [from the banks] was that we’re spending enough money on the actual development of the system, and to then go round with another hat and say, now capitalise this company so it can become a principal in the transaction, well that’s one step too far,” he says.

DrKW’s Wilkinson believes that either CLS should evolve to become a clearing organisation or another system should be put in place to clear foreign exchange trades, something that might not be that far off if London Clearing House Clearnet (LCH.Clearnet) has its way.

“Foreign exchange contracts is something we’ve been looking at, and we’ve been talking to banks for over a year now,” says Rory Cunningham, head of business development at LCH.Clearnet.

He adds: “Because LCH is an established clearing service, and not just for exchange business but for OTC interest rate derivatives, bonds and repos, we’ve already got all the systems infrastructure needed – we’ve got the connectivity to all the major players, we’ve got the collateral and payments facilities, we’ve got the expertise, and we’ve got the legal structures and regulations.”

Cunningham says that LCH.Clearnet might be ready to make a definite statement of intent at some point over the next few months.

But could this lead to problems for CLS? What happens if, for instance, the introduction of central clearing leads, as a by-product, to the elimination of Herstatt risk for trades put through the system? Would CLS have to evolve to meet this competition?

“We clearly have to consider that,” says Butterfield. “But at the moment the idea of turning this into a central counterparty is not on the board’s radar screen.”

Central clearing of OTC derivatives – a growing trend DrKW’s Alex Wilkinson believes that more and more over-the-counter derivatives deals will be cleared through a central clearing system because of the market efficiencies that come as a result. “We’re quite happy to see the OTC market begin to be centrally cleared piece-by-piece,” he says. Following the example of LCH.Clearnet’s SwapClear, which clears interest rate derivatives, Wilkinson sees it as only a matter of time before other markets follow. Foreign exchange is top of the list, but there are other products, such as credit derivatives, that could be well-suited to centralised clearing. “As the credit derivatives market evolves it will become more suitable for the full clearing process,” says LCH.Clearnet’s Rory Cunningham. “But,” he warns, “the more novel the contract the more complicated the issues around pricing, handling of defaults and margining become.”