CLS THREE YEARS ON: CLS set to corner settlement market

Take-up from banks, non-bank financial institutions and funds is increasing rapidly. In July, CLS settled an average 464,450 payment instructions per day with a gross value of $3.426 trillion, 22% up from the 381,302 record set on January 18. It currently has 245 banks, corporates and non-bank financial institutions and a further 288 investment funds.

But there is one chink in CLS's armour - corporates have largely failed to sign up. Only five corporates are currently active on it: Nike, Hewlett Packard, Skandia, Volvo and Renault Finance.

Clyde Muir, market manager for payments and cash management at HSBC in London, put the lack of traction down to the high cost of establishing an automated reconciliation process when finance directors have more urgent pressures. He says: "There was initially talk of regulators imposing sanctions on banks that failed to meet settlement risk, but this never happened. So, other regulatory requirements like Sarbanes Oxley have taken precedence over it."

But despite the weak link in the chain, CLS is racking up an impressive proportion of the overall FX market. The other major area that was lacking, the fund management community, has seen much more promising take-up, says Jonathan Butterfield, head of marketing and communication at CLS. "Some 30,000 settlements were carried out in the last three months. We expect this to increase four to five times once the custodian banks have the technology to enable straight-through processing, which should be at the beginning of next year."

According to a recent survey of 15 banks by London-based market research firm, Z/Yen, in 2004, its first year of operations, just under half of interbank trades were settled through CLS, with some banks settling 65% of their volumes through it.

The success CLS has seen to date has led most banks to believe it has achieved a scale that will force those banks not currently members to join. "It has passed the point of no return," says one head of FX at a global bank. "It has the scale now to make sure everyone is going to be on it."

While nearly all the major banks have joined, a couple of relatively big players still appear to be resisting the move. Allied Irish Bank is reviewing whether it will join, and says other regulatory issues had taken precedence, while Wachovia is understood to be set to join soon.

However, while most banks want to have access to CLS, most have decided not to become full members. Of the 245 banks on the platform, only 58 are settlement members. The remainder are third-party members that have chosen to bypass the extensive investments needed to be a full member. Currently, the cost for becoming a settlement bank is $5 million in shareholding capital investment on top of additional costs related to set-up, such as hardware, software and personnel. Infrastructure costs can vary depending on how developed the bank's existing infrastructure is, but can add millions to the cost of maintaining the relationship.

Commenting on his bank's decision to be a third-party member over a settlement bank, the head of FX says it came down to a cost-benefit analysis. "We haven't been able to identify the benefits of being a full member. If you are Citibank you would have to be a full settlement member, but if you are not a top 10 bank what are you going to achieve?" he says. "We found very little."

The ticket costs for settling over CLS have been at the centre of much debate over recent months. Based on a calculation that involves looking at the average daily volumes settled over CLS versus the monthly volumes a settlement bank pumps through the service, charges for settlement banks can vary significantly.

Nick Orchard, director, treasury operations at Credit Suisse in New York, says those banks that focus solely on ticket cost are missing the overall savings accrued from being part of CLS. Over half of all Credit Suisse's transactions, across all FX products and 75-80% of its interbank spot FX business is settled through CLS. "When you look at total cost per trade, settlement via CLS is generally cheaper than settlement outside CLS. The per-ticket cost for CLS settlement is more than offset by the operational efficiency savings CLS delivers. Investigations and compensation costs have been eliminated by CLS."

This view that CLS actually reduces costs was supported by the Z/Yen survey, which found that the cost of processing a CLS interbank trade in 2004 was $1.30, compared with $3.70 for a non-CLS interbank trade, and $5.80 for a corporate trade.

Jeremy Smith, director of financial services at Z/Yen, says the lower costs mainly arise from greater straight-through processing. "The static data is all set up in advance, confirmation process is automated and there are no fails," he says.

This has allowed many banks to scale up their FX volumes without additional processing staff. The report says CLS, coupled with additional IT investment, has meant many banks were able to increase their FX volumes between 2003 and 2004 with the same or less headcount. "Of the banks that participated in both this year's and last year's survey with the same scope, only two showed an increase in headcount alongside increased volumes," he says.

However, when technology costs are excluded from processing costs of interbank trades, the difference between the costs of operations of a CLS trade and the CLS fee, versus the operations cost of a non-CLS trade slid.

Smith says although CLS has helped reduce the cost, there is still a fairly significant cost in CLS fees, particularly for smaller banks, which negates some of the savings. "But we would hope CLS costs will drop as volumes grow," he says.

Orchard says the cost for settlement banks currently bottoms out at £1.13 per ticket. In order for all settlement banks to receive that charge regardless of their volumes, CLS volumes have to remain at around 213,600 trades on average every month. This should occur by the first quarter of 2006 or before, according to CLS estimates, he says. CLS declined to comment on pricing.

Currently, however, it is a volume game. Even third-party members say joining CLS only becomes viable if there is sufficient volume to put through. Michael Bailey, head of trading and sales at brokerage firm Fimat in London, says prices had come down significantly, although he declined to say what the charges were.

"We only made this decision as prices have come down significantly, but we would hope to see prices coming down further, giving us more of a price advantage going forward," he adds.

Fimat plans to be live on CLS as a third-party member by the end of September, using Société Générale as its settlement bank. Bailey says the decision to join was made to free up credit lines amid increasing volumes in the past two years. FX volumes have risen over 300% since 2003.

"Our volumes have been growing significantly over the past two years, where previously the cost savings weren't there," says Bailey. "But now our volumes are so big that it's flipped the other way, in that it alleviates all our line pressures by consolidating all down one bank."

Certainly, the benefits of CLS appear to have surpassed the elimination of Herstatt risk, or temporal settlement risk, to offering a way to clear up credit lines.

Stephen Dispenza, chief operating officer at brokerage firm Refco in New York, says joining CLS has enabled the broker to increase its bank lines. "The CLS banks we settle with will generally open up our settlement lines for spot," he says. The broker has been doubling its online volume every three months, which it partly attributes to its ability to expand its lines with the banks it is settling with through CLS.

Refco joined CLS as a third-party member in December 2003, using JP Morgan as its CLS provider. Currently it puts 60% of its daily volumes through the service. Dispenza says the remainder is either settled directly with its counterparties that it can't settle CLS with or via its prime broker, the Royal Bank of Scotland.

"It has also streamlined our settlement process and saved us some money in the overall cost of settling," he added. "The confirmation process has been simplified quite a bit." Dispenza notes that on a per-ticket basis, some of the trades are less expensive to settle than if the brokerage was charge on a per-million basis.

Dispenza says Refco is looking to expand CLS coverage to meet the needs of its expanding prime brokerage offering and direct business.

As more volumes go through CLS, the price for transacting trades through it will fall. That, coupled with the addition of more eligible currencies, is likely to result in more banks joining as third-party members and even settlement members. "As there are now nearly 600 CLS participants, and all the major FX banks are CLS enabled, it is likely that the introduction of new settlement members will be closely tied to the introduction of their home currency into the CLS system," says Credit Suisse's Orchard.