Author: Joseph Giarraputo

At a recent roundtable in New York hosted by The Bank of New York industry leaders discussed the progress of Continuous Linked Settlement. Global Finance’s Joseph Giarraputo moderated.


William Koleba

William Koleba, vice president, manager of the CLS project office at The Bank of New York: Continuous Linked Settlement (CLS) is a method of eliminating settlement risk for financial institutions’ foreign exchange transactions. It’s been live for about eight months now and not only has it been successful but it’s been growing in volume and growing in value of settlements.

Joseph DeFeo, president and CEO, CLS Bank International: CLS actually emerged out of a coincidence of events. In light of the tremendous growth in daily turnover in the foreign exchange markets, the G-10 central bankers realized that temporal risk—the so-called Herstatt Risk—had become extraordinarily large. At the same time, the FX Committee in New York had been looking at this because there were rumblings that the Fed and other central banks were going to “do something about it,” so the banks were getting worried. Simultaneously a group of bankers got together through the Swift organization to determine if the mechanisms for international settlements could be improved. Out of that emerged the idea of the CLS Bank.

KOLEBA: CLS is special in that you’re dealing with the settlement side of the transaction. You’re going directly for the real portion of the risk. You’re keeping the granularity of those trades intact and settling those trades individually.

DeFEO: One of the breakthroughs with CLS is the creation of a truly transnational structure. In order to achieve this we needed to exercise some of the frameworks that the G-10 governors put into place, and the mechanisms that were defined by Lamfalussy. So although CLS Bank is regulated by the Federal Reserve Bank of New York it operates under Lamfalussy guidelines.

Bill Filonuk, vice president, group head financial companies, The Bank of New York: To what extent were the central banks involved in making that happen?


Joseph DeFeo

DeFEO: We couldn’t have done it without their support. That was the breakthrough that enabled us to set up CLS Bank. Another key was that we set up a governance structure that ensured we had participation from all the countries and that there was no bias towards larger institutions.

KOLEBA: Are central banks considering participating in CLS as well?

DeFEO: The Bank for International Settlements (BIS) may become a settlement member and offer our third party service to other central banks so that they gain access to CLS.

Global Finance: CLS Bank has been live since September, with steadily increasing volumes. What is your opinion of its operation so far?

KOLEBA: We have worked with CLS as a pilot bank and are now glad to see live settlements occurring successfully every day. We are extremely comfortable with the operation.

Greg Barjak, vice president, head of operations, National Australia Bank, New York: We have been up and running from some time with our Australian and Asian operations in CLS Bank. Our London operations went live recently and within a matter of weeks close to 40% of their daily interbank foreign exchange activity was being cleared through CLS Bank.


Joseph Giarraputo

KOLEBA: With CLS everyone is somewhat apprehensive at first because it’s new, but once you’ve implemented it’s easy.

BARJAK: Once you make that first step and dive in, you’re up and running and the process flows.

KOLEBA: Although CLS had a few system problems they have managed them well and consequently built a stronger and more reliable process. As a result it’s increased the efficiency of the back office.

DeFEO: One of the things that has given confidence to shareholders and particularly to the central banks is that we’ve had these disruptions and they’ve all been managed.

KOLEBA: Typically trades will settle in the first two hours, even though the actual payments are going on for an additional few hours. In fact on most days trades settle within the first hour.

GF: How will CLS Bank work for fund managers and their custodians and what impact do you expect it to have?

FILONUK: From a custodian’s or a fund manager’s point of view there are two things that change. First, the fund manager must provide the custodian with instructions in a proper form to tell them the instructions should be settled via CLS. Second, there is a need to report back the results of the matching process because the custodian bank wasn’t a party to the trade itself. This is most important if there was a problem in the match. CLS has very tight tolerances.

KOLEBA: The tolerance is one unit of currency or 100 Japanese yen.

FILONUK: The Bank of New York is acting as the outsource agent for fund managers. In those cases, we retain control over all of those information flows. So the areas where we would have needed to provide these communications tools, we’re actually doing that on behalf of the fund manager.

Keith Walker, head of trade processing, Gartmore Investment Management: We deal with about eight main counterparties, all of whom are CLS members. As we trade with those counterparties we then currently send instructions to the client custodians via Swift to settle those trades. We are intending to continue to match with the counterparty before we send the instruction to the custodian to settle. We feel that we can get our counterparties to confirm to us within half an hour and then get the instructions out to the custodians to match in CLS. In that way we don’t believe you will have many matching problems.

FILONUK: There may be occasions where a mismatch occurs, though.

WALKER: Yes, and we will put in the procedure to ensure that as soon as we get that non-matching information we get onto the counterparty to make sure they match the trade in CLS.

GF: What’s, what’s your motivation to settle through CLS?

WALKER: Mainly, it gives us the benefit of FX netting without having to build our own netting system. At the moment, where we’re doing currency overlay-type transactions, in nearly all cases we’re settling each trade separately. In CLS we would be able to net them. Another benefit is that CLS takes out settlement risk.


Greg Barjak

BARJAK: Fund managers see CLS providing them netting capability, which reduces further the risk in the settlement process.

FILONUK: Another great benefit of CLS is the matching up-front. That reduces the settlement costs associated with FX trades.

WALKER: We also have issues where custodians are expecting money to come in from one counterparty that they have to pass to another. There’s currently some reluctance to release that money until they see the funds in their systems. I believe CLS will eradicate that issue.

KOLEBA: The custodian that has payments to be made realizes the funding for those payments is coming through CLS and, because of CLS’s settlement finality and timely processing, clearly knows that those funds are in place.

GF: What sort of new developments can we expect to see in CLS?

DeFEO: We’re talking to a number of parties about cross-border derivatives. And we’re testing what we’re calling a second session, which would allow us to deal with same-day next-day trades, especially in the dollar Canada market. CLS may also have a role to play in the cross-border securities market. We could be the P in cross-border PVP (payment-versus-payment). CLS could certainly help make the clearing process more efficient, from the point of view of the currency settlement.

GF: Let’s talk about some of the services being offered to third parties.

KOLEBA: We see some enormous opportunities here. The big story is the merging of several discrete processes—the confirmation process, the payment process, the settlement process and finally the reconciliation process. We’re giving our clients a browser-based tool called SafeSettleSM that allows them to manage the process from beginning to end. They can immediately see trades going into CLS, see counterparties agreeing to those trades within the prescribed two hour best practice, and see the status of those trades in advance of and during the settlement process. We even give our clients tools to deal with a settlement failure.

BARJAK: The reconciliation and confirmation process is key here. For a client to have the ability to view the progress of that trade is a big benefit.

DeFEO: A lot of banks have been seeking this for years. There are some that say payment matching could eliminate the need for the confirmation match.

BARJAK: So we’re taking the fact that the trade has confirmed in CLS for payment as the default for the confirmation. By default the trade has been confirmed.

KOLEBA: The whole purpose of the trade is to exchange two currencies in a given value date. So if the other parties agree to do just that through CLS Bank, why go through a separate confirmation process?

DeFEO: That could lead to actual out-of-pocket savings if you’re paying for a matching service.

KOLEBA: We’re seeing that with some of our clients. We give them our SafeSettleSM product, we show them how easy it is to manage the entire process and they essentially start to discuss how they can streamline their process through simple and timely reconciliations. We provide summary information so they can quickly see exactly where they stand in their positions.

BARJAK: If every bank you were dealing with in the interbank market was settling through CLS it could eliminate the need for an in-house or vendor products to facilitate the matching process.

DeFEO: There’ll be a preference amongst banks to deal with others that are settling through CLS because it’s lower cost, lower risk. They’ll have wider trading limits because of the reduced settlement risk.

GF: Has settlement risk been reduced by CLS and have other risks been introduced or increased?

KOLEBA: Although we have seen settlement risk being eliminated for CLS-settled trades, there is an offsetting increase in liquidity concentration risk and operations risk. The operations risk is due to the demands of the timed pay-in requirement imposed by CLS on its settlement members. The liquidity concentration risk develops due to limitations in the participants and instruments currently involved in the CLS settlement. CLS assists its members in managing liquidity by facilitating Inside/Outside Swaps, a process that identifies offsetting liquidity concentrations between settlement members and arranges trades which reduce those concentrations. As we bring on fund managers, consider adding money market transactions, and support same-day trades, these concentrations will decrease and the liquidity and corresponding operations risk will also diminish.

DeFEO: Addressing the other risks, I believe if we were going to experience pay-in failures due to operational problems it would have occurred already.

WALKER: We get the benefit of netting. That gives our custodians comfort when they are paying out large amounts because they will see they’re getting in the cover from the counterparties. And the payment-versus-payment (PVP) takes out the settlement risk.

GF: Will there be a pricing differential for CLS processed trades?

KOLEBA: The key here is the regulators. If they impose capital requirements to cover some of the risk there’ll be a real cost to settling trades outside CLS.

DeFEO: As the regulators hear positive feedback about CLS it will encourage them to do exactly that.


Bill Filonuk

FILONUK: The industry may decide for efficiency reasons that CLS is their preference and price in the direction of preference for CLS.

BARJAK: Regardless of the efficiencies that are gained there’s going to be a point where the regulators may say, “We’ve got 60, 70, 80% of the business in CLS and for those in the market that continue to choose to settle outside of CLS a risk capital charge may be applied.”

GF: Is CLS leading to cost savings?
DeFEO: More and more of our shareholders are becoming willing to say they’ve seen savings in the back office.

FILONUK: Even if you put the cost of implementing CLS in the equation, with the ability potentially to manage the treasury positions more efficiently and the savings of overdraft costs caused by failed settlements you may have avoided, the equation nets out positively.