Most of the banking community is aware that Continuous Linked Settlement, or CLS, is coming, but fewer fully appreciate the fundamental change in financial market infrastructure it will bring.
CLS will affect the market in three major ways: Settlement risk in cross-currency transactions will be eliminated; new real-time facilities will supply previously unavailable continuous settlement information; and the management of liquidity and cash will be significantly improved. New CLS Bank International funding requirements will also pose challenges, as for the first time banks will need to make liquidity available at specified times - so-called timed payments - to satisfy the funding obligations necessary to support settlement.
CLS will replace a method of cross-border settlement that has been in place for more than 300 years. Even today it normally takes at least two days to settle trades and even longer if reconciliation issues and/or holidays are involved. CLS Bank is unique in that it manages a process linking the central bank Real Time Gross Settlement systems in the new five-hour window of their overlapping business hours, through a process that gives CLS Bank settlement finality and certainty similar to these systems'.
Cross-currency transactions are growing at a remarkable rate. The foreign exchange market alone has grown by about 43% since 1995, and cross-border transactions are expected to double each year for the next three years, reaching 600,000 a day by 2003. However, underpinning the market's stability is an assumption that the system is safe and that parties in a cross-border transaction will get the currency they have bought or the proceeds of a sale upon settlement. Without this basic assumption, chaos would reign in international markets.
This network of trust, and ways to maximize it, have been under scrutiny by the regulators and the market for many years. Collapses such as that of Bankhaus Herstatt, which went into liquidation before submitting required payments to U.S. counterparties in the 1970s, have illustrated the risks involved.
Concern over these risks led to the Allsopp Report in 1996 and the creation of CLS Bank by the world's leading foreign exchange trading banks a year later.
Once up and running, CLS Bank will eliminate the temporal risk in cross-currency payment instruction settlement, substantially reducing risk to the whole FX market.
The simultaneous exchange of value between settling parties (so-called payment versus payment, or PVP) introduces more certainty into the transaction process, which will benefit the market generally. As the process is based on PVP, CLS Bank neither takes on the risk itself nor transfers it to any third party. If a transaction does not meet the strict settlement criteria for both the payment instructions received by CLS Bank from the parties and for their total net balance with CLS Bank, then the instructions do not settle, and no funds are exchanged, protecting the principal of both parties.
CLS Bank will maintain links with the relevant central banks' Real Time Gross Settlement systems that will enable it to do global settlement with a degree of finality and certainty for CLS-settled trades similar to that provided through a domestic RTGS.
In addition to temporal risk, CLS Bank can reduce some of the risk associated with liquidity management. Central to this is CLS Bank's alignment to the five-hour operations window during which the participating central banks have overlapping opening times. This enables cross-currency transactions to be settled and funded on the same day. In this window, eligible settlement instructions for a particular date are settled and funds are requested and paid out by CLS Bank.
Each settlement member of CLS Bank will get a pay-in schedule that details the member's net position in each currency and when payments to facilitate settlement are required in each currency. This will enable them to reduce liquidity risk because payments are required solely on the net position of all settlement instructions made in each currency rather than on a trade-by-trade basis as is true now.
These multilateral, netted positions reduce funding which would be necessary for the gross total individual instructions by up to 90%, and they let banks vastly improve the leveraging of the total liquidity available.
Banks will also be able to better manage their liquidity, as for the first time they will be able to see in real time which transactions are settling and get accurate projections on the net payments that will be received or will require funding in each currency. This will also pose challenges because the requirement to fund obligations to CLS Bank at specific times means that banks will need to carefully manage their intraday, that is, CLS Bank "day," liquidity requirements to ensure that obligations will be satisfied. This in itself will change the way the market works.
In order to achieve these market benefits, CLS is working toward going live with a limited number of shareholders in October, followed by other shareholders in groups until March 2002, at which point shareholders will be able to submit third-party instructions for settlement member customers. We are determined to make CLS Bank work and expand its use throughout the market. This is underlined by the fact that we are in discussions with six other central banks to bring their currencies into the system.
CLS is bringing a radical change in the way the market works - as well as unique market benefits. It is the first time that the RTGS systems of the major central banks have been linked in this way to extract the potential of domestic payment certainty and finality. Real-time settlement information will improve the management of settlements and assist in cost reduction and error tracking. Above all, CLS will ensure that cross-currency settlement risk is a thing of the past. Many challenges remain to be faced, but it is clear that the market opportunities are huge, and we have hardly begun to scratch the surface.
Mr. De Feo is chief executive officer of CLS Group and president and chief executive officer of CLS Bank International in London.
