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Page last updated
February 15, 2003

 

 

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Continuous linked settlement - an agent for radical change

www.logica.com

Many things determine the balance of competition in the international banking community, but many banks are finding the pace at which they must adapt to competitive pressure is increasing, with concomitant changes to the urgency of the development projects which are then triggered. Within Europe, in particular, the introduction of the Euro is forcing banks to differentiate their customer offerings at a greater pace than before; other areas have perhaps been exposed to increased competition over a longer period of time. Continuous Linked Settlement ("CLS") is one of the factors which will accelerate this process, and will result in continued rationalisation across the banking community.

No-one doubts that CLS will change many aspects of business and systems processes in banks. Plans for handling the deep-seated changes to infrastructure are already advanced at those banks which will be the first to use CLSB for settlement. Banks are already looking at how to adapt systems used to coping with simple settlement netting, bilateral and multilateral netting to the new world of CLS. However, this "bottom up" view sometimes masks a misunderstanding of the way in which CLS will change the very nature of the foreign exchange markets. CLS is most emphatically not simply another payments system, inviting compliance from its participants, but a powerful agent for change in its own right, and for a variety of reasons.

Regulators may have inspired - and driven - the move, but there are many ways in which a forward-thinking bank can turn it to its advantage. CLS offers many new business opportunities, while threatening many of the older practices still redolent in so many leading banks. The initial challenge is to look at the effect which CLS will have across the departmental boundaries which protect so many of the individual fiefdoms within a "typical" bank. Areas which are often managed completely separately will have to co-operate in new ways, and their processes will have to be re-engineered to support these changes.

Today, many correspondent banks regard settlement of foreign exchange transactions as a core business, providing relatively stable, fee-based profits. The operational difficulty so many banks experience when attempting to change their major clearing agents only serves to increase its attractiveness as, once a bank has moved its business, they become reluctant to contemplate moving away. This attitude, however, ignores the obvious risks inherent in moving large sums of money, and the widespread obvious lack of concern for these risks was a major factor influencing the move towards CLS by regulators in the first place. The various netting systems which were available to banks, although proven to reduce volumes substantially, did not attract the critical mass of membership required to revolutionise the industry. Under CLS, the sums moved will decline substantially, by comparison to the volumes of trades enacted, and risk profiles will change across the entire industry.

In order to survive, many correspondent banks will need to look at new strategies to replace lost earnings, and some will be drawn to the new role of liquidity provider.The focus on the ability to provide liquidity will generate an opportunity for banks to move away from their previous stance of mis-pricing the risks inherent in money transfer, and the hopes of the regulators must be pinned on these changes. A small number of time-critical payments will replace the bulk business of moving large sums in huge volumes of transactions. The lengthy courtships played out in todayŐs markets will be replaced by ever more stringent service level agreements, defined and monitored by advanced technology in real-time. Where will this leave the banks with lengthy enquiry backlogs in today's market? The investment in CLS compliance will leave the new generation of multi-currency providers looking for early returns on investment, and the potential customers eager for a pound of flesh. Pricing will have to be rethought, and new strategies played. The risks inherent in the new trading protocols must be assessed, and the remuneration sought pitched at the correct level, or the dynamics of the business may become skewed; in any case a shrewd eye must be cast towards the competition as they may rewrite the rules of engagement almost overnight. The nature of CLS correspondent banking will cause much heart searching among many smaller banks who still want to keep a presence in this market: for many CLS will prove to be the final straw.

Foreign exchange trading will become polarised between the CLS and non-CLS camps. Banks will have to think carefully how their trading policy should be formulated towards non-CLS members as the costs of advanced credit monitoring for this group may be relatively costly and not easily recoverable. Volumes may or may not make heavy investment in non-CLS trading worthwhile. Many banks are hoping to tackle the operational challenges of CLS now, while hanging back on developing detailed trading policy. If these banks start to move at the same time, a landslide effect could be caused, and CLS settlement would quickly establish itself as the norm. The challenges presented at an operational level are no less revolutionary. Today few truly international banks control global branch accounting in any currency over a single account, but CLS will render this commonplace. Settlement within CLS will take place according to the pay-in schedule calculated by CLS itself, which will also drive the programming of payments on behalf of user members. The values concerned are probably small by today's standards, but the effect on payment systems could be significant. Certainly, the removal of even small numbers of payments will give rise to some difficulties at times when traffic flow is critical. The problem of liquidity management under CLS is compounded because few people are willing to predict the precise level of usage at this stage. As smaller payments in a real time gross settlement system habitually oil the wheels of the entire system, the removal of significant numbers of payments in a single size class will have far-reaching effects on liquidity and efficiency. If a payment system relies today on differential distribution of payment size classes, as most do, in practice, then available liquidity will fluctuate far more widely under the CLS regime than is the case today. Today, many smaller clearing banks can more or less ignore liquidity management as a discipline: under the CLS regime, this attitude will be seen as a costly folly. The possible dearth of liquidity at crucial times in the payments cycle will be created as much by the existence of time-critical payments settling CLS obligations, as by the removal of substantial numbers of payments from settlement at other times of day. This multiplier effect will be exacerbated by the fact that not all payment size classes will be affected equally by CLS.

All banks engaged in the settlement of CLS currencies will have to invest in more complex payment scheduling and liquidity conservation mechanisms. Reconciliation today is often handled, even at quite large and well-respected banks, the morning after settlement: under the CLS regime, reconciliation during the day is a necessity, with most banks looking to predict liquidity flows in real time and manage their customers in a far more pro-active way than is the case today. Banks will monitor performance of clearing systems more closely, and draw more direct comparisons, while starting to count the cost of releasing other payments traffic early in the day, as so many do today. Payment netting systems will come under closer scrutiny, as the true costs and relative efficiency of these systems will emerge. Banks will move to the integration of intra-day credit and liquidity to conserve scarce resources, and will look to the new generation of management techniques, integrating all these processes with collateral management. Major clearing banks will come into their own as providers of timely, sophisticated information to their customers, and reap the reward of being able to charge for innovative services, while those banks unwilling or unable to invest in the new technologies of prediction, monitoring and management will pay the heavy price of failure.

Techniques are now available to monitor clearing performance and provide early warnings integrated across different hardware platforms: these tools will be made available increasingly to larger clearing customers as a way of facilitating the difficult outsourcing decisions that will have to be taken. It is likely that provision of such tools will spread down to far smaller customers as clearing volumes and the sheer numbers of payments fall: after all, if payment volumes fall dramatically, smaller customers become disproportionately important to the bank as a source of continuing revenue. Exposure to delays will become far more critical for both clearer and customer, and no bank will be able to affords the luxury of manual processing, or entertain the possibility of losing payment transactions in a complex, poorly-understood queue structure.

The new liquidity management and predictive monitoring tools, will also come into their own in the global move towards delivery versus payment ("DVP") in the securities settlement market. In the UK the advent of DVP will also cause liquidity to fluctuate considerably during the day, the more so as the very large securities transactions processed today will have to be committed to settlement in real time, during the business day; other systems will experience a similar if perhaps diminished effect. The experience gained in intra-day reconciliation within the CLS world will also be used to great effect under a DVP regime.

Banks succeeding in this volatile new environment will be those where the provision of information technology corresponds to the business needs of the end customer, where complex information is passed freely from back office to front and beyond in a timely and straightforward manner. Support for these processes must be unwavering and closely defined. Project management skills of the highest quality will assure this process, while the implementation and delivery of the new generation tools will require considerable intellectual efforts. Most banks will be casting about for professional help to meet the sheer scale of changes implied by CLS, to perform impact analyses across the business affected, and to build on their findings in an objective and systematic way. Whole processes will need to be re-engineered, and ever more critical pieces outsourced as core competencies become more apparent. Banks choosing the path of employing others to settle CLS trades on their behalf are even now starting to look far more systematically and critically at the claims of potential clearing agents, and engaging external help for this complex task, as, despite their experience in money transfer disciplines, they recognise the far-reaching nature of these changes.

CLS will bring 24 hour trading into a new dimension. It will blur the traditional lines drawn so conveniently between intra-day credit and overnight credit, to which banks have been accustomed since Bankhaus Herrstadt first got into difficulties, and which have defined so much of their policy and strategic thinking.

Sun Tzu, the great Chinese military strategist relates the story of how a general undertook to train the emperorŐs concubines to become an elite fighting force. The general formed two groups, and gave the command of these groups to the emperorŐs two favourites. He then gave some clear instructions, and repeated them. When the girls failed to react, he had the two chief concubines beheaded, promoting two others to command, to focus the minds of the remainder on the tasks in hand, which was then evident from the attention paid to further instructions. The emperor was duly impressed, and ordered a halt to the training before he lost more of his favourites. The big question which CLS poses is how many banks will fail to appreciate that the ground rules of the game have changed. Unfortunately, there is probably no banking equivalent of the emperor in these egalitarian, market-driven times.

Anita Bradshaw
Senior business consultant,
LogicaŐs Financial Services Division

 


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