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CLS: Complex but not Complicated
Worldwide simultaneous deal settlement across five time zones and seven currencies (with more scheduled to be added) to ensure zero settlement risk seems like a complex task. This is the goal of CLS Bank, and from a Settlement Member's point of view, it is quite complex. Despite the complexity, the benefits of CLS are numerous to all participants whether their status be a Settlement Member, a User Members or a Third Party: elimination of settlement risk related to foreign exchange deals, more efficient operations (rationalisation of nostro accounts, easier tracking and reconciliation), increased counterpart limits for the front office and efficient management of multi-currency cash for the treasury department. However, depending of the user's CLS status, not all is equal in terms of the preparation and day-to-day business that is required to be able to reap these benefits. Acting as the pioneers of new technology, building internal systems which touch the heart of the bank's operations, implementing adapted back-office organisation and creating new multi-currency liquidity management strategies are some of the major hurdles that a Settlement Member must overcome to be prepared for CLS.
Although the concept of CLS and its implementations for a Settlement Member are complex, a Third Party is in a unique position since it may participate in CLS in a much less complicated way. The capacity of a Settlement Member to bring forward the advantages of CLS to its Third Party clients while distancing them from the inconveniences is a major factor which determines the quality of the Third Party service. Apart from the costs incurred as a Settlement Member (which are a non-negligible factor), this article will examine the ways in which a Third Party can fully benefit from CLS despite the complexities which are borne by the Settlement Member.
The first aspect to consider is the systems adaptations that must be coherent with the CLS mechanism. A Settlement Member interfaces with CLS via a control branch which involves the creation of a new technological environment based on SwiftNet, gateways, servers, workstations, etc. The Third Party will be able to access CLS without nearly the same technological implications as a Settlement Member. Since technical solutions offered by Settlement Members will vary, there will be a direct consequence in the changes that must be made on the Third Party's end. An easy integration solution includes the possibility for a Third Party to rely on the same technology that it he familiar with today: standard SWIFT Fin messages and internet access to view account activity. To ease the integration process, the Settlement Member can play a consulting role in this matter as the best solution will take into account a number of factors: current applications used by the Third Party, its "go live" target date, its size, etc. There are even certain clients who may choose a plug-and-play option which consists of integrating a software, but avoiding core systems changes.
Another factor that makes CLS less complicated for Third Parties is that a Settlement Member, on the front line, must actively manage all of the information flows (relative to deals and statuses) directly with CLS. The settlement member must also constantly be concerned about the positions, limits and risk that these flows generate. This supervision can be complex as it requires management from its control branch as well as its internal branches and Third Parties. Due to the nature of CLS, this requires the Settlement Member to be active 24 hours a day. Third Parties are sheltered from this complexity as they benefit from the Settlement Member's conception of the product and the tools which allow them to enjoy a much passive role while maintaining virtually a direct relationship with CLS.
By providing relevant information at the appropriate time via a proper mix of communication channels (SWIFT or via the internet), Third Parties will be sufficiently prepared in advance for the settlement day. Assuming that the Settlement Member is capable of intelligently managing the information, the Third Party will know how to manage the information in function of its importance and will be able to react accordingly as shown in the diagram
Several days before settlement, the Third Party has all the relevant information about his deal information (statuses) and positions on a real time basis. At this time, the Third Party has little action to take (except the management of his own deals; for example internal matching, modifications, cancellations etc.). When the day before settlement arrives, the Settlement Member will have already informed the Third Party of any problems such as unmatched deals or positions outside limits. This will have given enough time for the Third Party to take corrective measures. When it comes time for settlement, the Settlement Member must pay CLS specific amounts at specific times starting at 7am CET. Depending on the degree of flexibility that a Settlement Member allows with its Third Party clients, the Third Party may not be obliged to fund in the same manner. In function of this flexibility, the Third Party will have already been prepared so as to minimise the impact that the funding will have on his operations and treasury.
Third Parties are also sheltered from other specific constraints that CLS imposes only on Settlement Members. For example, in case of a technical problem or a liquidity shortage in a currency, CLS may require Settlement Members to advance funds without notice in a very short delay (around _ hour). This can take place as early as 8:00 CET. Such liquidity calls could be an inconvenience for Settlement Members, but depending on the relationship between the Third Party and the Settlement Member, the Third Party will not be have to be subjected to liquidity calls on behalf of the Settlement Member.
Finally, liquidity management will be much more complex for a Settlement Member than for a Third Party. One of the ways in which the liquidity will be managed between Settlement Members is through the IN & OUT swap. Although IN & OUT swaps are a very useful tool in reducing the Settlement Member's positions that will actually be settled with CLS, other inconveniences must be dealt with such as counterpart risk and the uncontrollable timing for the reimbursement of the OUT leg. As a Third Party, the liquidity management is not complicated since it is ensured by the Settlement Member. The Third Party will have a very clear picture of the amounts to pay for each currency the next day based on its net positions and does not participate in such complex liquidity schemes to manage his liquidity.
In conclusion, due to the Settlement Member's front line role that it has vis-a-vis CLS, it is prone to a high degree of complexity. The integration of new systems and technology, the management of information flows, the organisational changes to operate around the clock and the unpredicted aspects of liquidity management are a few examples of the complexity of CLS from a Settlement Member's point of view. Settlement Members who have a credible offer for Third (and Fourth) party services will have considered all of these complex implications relating to CLS and will have transformed them to be as less complicated as possible for their Third Party clients. Therefore, the Third Party will be able to enjoy the benefits from CLS while avoiding the complexity and costs incurred by a Settlement Member.
Extending CLS Third Party
Services to encompass internal and external clients
Third Parties may be interested in such services for several reasons. If the Third Party is organised around a group of decentralised subsidiary companies with different legal statuses (asset management, arbitrage, insurance, etc.), it can allow the main Third Party branch to offer a homogeneous "group" access to CLS. The main branch would act as the Third Party and each subsidiary would be linked to the Third Party either directly or indirectly. This allows a Third Party to determine the independence of the group's dealing, treasury and/or back-office functions. In the case of Fourth Party services, the Third Party's incentive is to adopt a defensive strategy in an effort to maintain its external client base whether they be SWIFT corporate clients or other financial institutions. Third Parties may fear that potential Fourth Parties may be tempted to move their business away to a Settlement Member who offers both clearing and Third Party services. In order to retain clients, a Fourth Party service will allow Third Parties to offer similar packages as a Third Party provider.
Assuming that the Settlement Member's systems are capable of managing such situations, the offer is very similar to that of the classical Third Party service. There can be a large degree flexibility requested depending on the Third Party's relationship with the different actors. The diagram below shows a few of the many ways the relationships can be organised:
Third Party providers can offer different levels of customisation which will render the service more or less white labelled. Some of these choices will have an impact on the role and the workload that the Settlement Member or the Third Party will have vis-à-vis the Third Party's Branch, Subsidiary or Fourth Party client. Below is an example of the choices which must be carefully thought about between the Third Party and the Settlement Member:
n How are the deals for each unit going to be sent to the Settlement Member? Will they be sent directly to the Settlement Member or will they be first sent to the Third Party for control?
n What input methods can be used (SWIFT, internet, file transfer)?
n What type of reporting should be sent to each unit? In which cases should the Third Party send information to the individual units and in what cases should the Settlement Member directly inform the units?
n Should the units have to adapt their existing nostro relationships?
n How should the customer service be set-up?
n How should invoicing and interest charges be handled?
Another important aspect is that of risk management, especially in the case in which deal confirmations are directly sent to the Settlement Member. As the Third Party outsourcers part of its risk management to the service provider, sufficient controls such as real-time limit management by the Third Party and the possibility for it to block deals must be considered.
Such arrangements add a new layer to the basic Third Party offer. Undoubtedly, adding a new layer adds a new degree of complexity to the service, especially if a high level of customisation is required. Depending on the objectives and organisational constraints a Third Party has, it can work together with its provider to determine the best solution so as to make the service as easy as possible for all parties involved.
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