CLS must evolve, or face competition

Certainly, no-one could argue that CLS hasn't played an instrumental role in the development of the foreign exchange markets since its inception in September 2002. In the July CPSS report, the Bank for International Settlements said CLS settles 55% of the world's FX trades. That's a real achievement given the number of aborted attempts to tackle Herstatt risk in the past.

Similarly, CLS has played a major role in credit risk reduction. Many members confirm CLS has contributed to the growth of the FX market, increasing trading capacity through risk reduction and greatly improving operational efficiency and scalability. Having done so, these firms have now optimised all these and related processes to support further business growth. This is a big industry achievement and one appreciated by regulators as they continue to challenge the industry to eliminate settlement risk.

But it has also led to a number of FX businesses outgrowing CLS, with others likely to follow. This is not least because of the increase in algorithmic trading clients and retail traders. Both client segments continue to push through an increasing number of tickets of decreasing notional sizes, putting pressure on the costs of processing these trades profitably.

So CLS faces a predicament. Some banks serving these client segments are pushing to net trades pre-settlement to relieve both the resulting back-office capacity constraints and the costs of settling through CLS. However, the CLS board, in consultation with every prime broker in the industry, has decided to reject netted trades for settlement, in part due to its unequal impact. Despite this, at least two banks, possibly three, are already netting CLS eligible trades, which will now have to be settled outside CLS.

What seems to be happening is a dislocation between the desires of the trading desks and the settlement operations within CLS member organisations. Whatever the reasons for this, the risk for CLS is that other settlement systems are going to emerge that serve those it has refused. And if these systems cover Herstatt risk to the same degree as CLS, regulators would have no reason not to support them.