CLS is a vital piece of global financial architecture. Settling more than half of all FX transactions in the market – approximately $5 trillion per day – its core function is to eliminate settlement risk among its members in the FX market.
It has operated without any interruptions since launching in September 2002, allowing counterparties to trade without taking on credit exposure to each other.
The Bank for International Settlements’ committee on payment and settlement systems embraced FX settlement as one of its initial, defining projects, and describes the work of CLS since 2002 as “one of its major, enduring successes”.
And the US Financial Stability Oversight Council classes it as a systemically important financial market utility. Only eight institutions have this designation, including the Chicago Mercantile Exchange and several subsidiaries of the Depository Trust & Clearing Corporation, such as the Depository Trust Company.
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Hungarian forint |
When the forint is added to the CLS system, expected in November, institutions will be able to trade the forint without having to worry about the credit risk of the institutions with which it trades. This should also encourage other institutions to trade in the currency, increasing liquidity.
Russell Dinnage, senior consultant at GreySpark Partners, says: “Settlement risk is the primary risk in the FX market, and by mitigating this risk CLS will enable increased trading in forint, which could even feed through to increased imports and exports.
“It will also make the forint a more tangible asset and reduce the need for positions to be hedged, which should increase liquidity.”
The more currencies that come on board, the more effective the system will be. Adding new currencies is a time-consuming process, but having worked with the Hungarian central bank Magyar Nemzeti Bank (MNB) for around 18 months, the date for the forint’s accession onto the system is fast approaching.
David Puth, CEO at CLS, says: “Central-bank support is an essential component of adding a new currency. A certain amount of foreign-exchange activity is also necessary to make the addition of a currency commercially viable for CLS and our shareholders.”
Diligence
MNB says its preparations for including the HUF in the CLS system are progressing according to plan, the diligence phase having been completed at the end of 2014.
“The tasks ahead include the clarification of legislation, the harmonization of IT systems and the modification of the central bank’s account management policy and business terms,” it says.
However, it is not just the central bank that has work to do to prepare for the change. Financial institutions, both Hungarian and international, must also adapt their systems in preparation.
“The foreign participants of the system must find a forint account manager through which they can execute their settlements,” says the MNB in a statement to Euromoney. “In addition, Hungarian credit institutions must also build up their own access to the system.”
Some reservations have been expressed that this process can be completed ahead of the November deadline.
It is quite surprising we will be the first currency in the region to be added onto the CLS system György Éder, Raiffeisen Bank |
György Éder, head of trading at Raiffeisen Bank in Budapest, says some local banks in Hungary that would provide nostro accounts to CLS clearing members do not have sufficient collateral – mainly Hungarian government bonds – to pledge to provide intra-day liquidity in extreme market situations.
“At a time when many banks, especially Anglo-Saxon banks, are reducing their balance sheets, Hungarian banks may need to increase theirs in order to have the necessary collateral,” says Éder.
“Since some clearing members are still searching for HUF nostro partners with CLS service in Hungary, local banks looking for settlement availability are turned down by these CLS members. There is some concern about whether this can be resolved before the November 16 go-live date.”
However, this problem should ultimately be resolved, and MNB says the addition of the forint onto the CLS system, ensuring Hungarian banks settle their own foreign exchange turnover using the CLS service, is a priority.
“There is a sufficient amount of liquidity in Viber [Hungary’s real-time gross settlement system] for the processing of morning settlements,” it says. However, it hopes the redistribution of liquidity will enhance the role of the Hungarian interbank market after the launch of the system.
It will certainly be a welcome development for Hungary.
Éder says: “Hungary is still an emerging market, especially in terms of liquidity in bonds, interest-rate derivatives and nowadays also in FX.
“Before Lehman it was the opposite, everything was liquid, but the regulatory focus on trading activity and risk changed that. Today around 90% to 95% of HUF interest-rate derivatives, traded mainly in London, are centrally cleared and that has not made much difference to liquidity. Hopefully CLS will have more of an impact on forint liquidity than clearing did for interest-rate swaps.”
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Russell Dinnage, |
He adds: “It is quite surprising we will be the first currency in the region to be added onto the CLS system, ahead of the Polish zloty or Czech koruna, but it is easy to see why the central bank is pushing for it.”
CLS had been in discussions about adding the rouble last year, with plans reaching a relatively advanced stage before the deal collapsed under the weight of geopolitical pressures.
Indeed, at the start of 2014, when the Hungarian Banking Association was preparing for CLS accession and working towards an April 2015 deadline, it expected the forint, rouble and renminbi to join at the same time.
Instead, the next currency after the forint looks likely to be the Turkish lira, which is set to be added to the system next year. CLS is also in discussions about the possibility of adding the renminbi, in either its on- or offshore incarnation. However, it concedes the latter currency is a longer-term goal.
The most recent additions to the system were the Mexican peso and the Israeli shekel in May 2008, before which came the Hong Kong dollar, Korean won, New Zealand dollar and South African rand in December 2004. When the forint is added, it will be the 18th currency settled on CLS.
However, new currencies are just one part of CLS’s growth strategy. The group sees opportunities for growth both in taking on new shareholders – it currently has 62 settlement members and 76 shareholders – as well as expanding the services it offers.
CLS’s Puth acknowledges: “Bringing a new currency onto the platform is the way in which CLS can most effectively add new business. [But the group also] seeks to grow business through expanding participation from new and existing members, and by adding new products.”
Regulation
Some of these plans are now close to fruition and it is shaping up to be a busy second half of the year for CLS. It will launch an FX forward compression service, in collaboration with TriOptima, a provider of post-trade infrastructure for OTC derivatives, by the end of the year.
“Since the enactment of Dodd-Frank legislation in the US and the European Market Infrastructure Regulation (EMIR) in Europe, the regulatory authorities have emphasized the importance of compression in reducing notional principal exposure for individual institutions and for the clearinghouses,” explains TriOptima in a whitepaper.
By enabling participants to reduce the number of trades and limit their gross notional exposures, the CLS and TriOptima service will reduce counterparty credit risk and leverage ratios, they say. It will also help institutions comply with EMIR, Basel III and Dodd-Frank.
Another big plan is to settle cross-currency swaps, a project it is working on with MarkitWire, a global trade booking and affirmation platform, as well as central counterparty clearing houses. This will see it add the principal exchanges involved in cross-currency swaps for settlement to its existing settlement service.
Cross-currency swaps are mandated for central clearing, but a suitable settlement risk-mitigation model is required. This deal will see MarkitWire sending payment instructions on behalf of clients to CLS for settlement.
“A number of banks have demonstrated interest in the service and several have already committed to working with CLS and MarkitWire in the development and use of this service,” says CLS.
No date has been set for the completion of this initiative, but it hopes this will also be live by the end of the year, subject to regulatory approval.