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Page last updated
February 15, 2003




CLS; It will be worth having waited


CLS; Late? Yes. Ready? Yes. Worth having waited? Yes
Tales of the unexpected. Following hot on the heels of the English cricket team's resurgence, CLS is now ready for to go-live in September, offering the real prospect that readers of this SIBOS edition will finally get to talk about something that is up and running. At the end of July, thirty-nine of the world's largest banks started the last of four test stages. The first three proved that the banks are ready and that the core CLS system has been able to perform in a productive environment. This article offers some background on the tests and comments on the readiness of the early adopters, and highlights the importance of mutli-currency nostro services and the signs of its increasing importance for potential Third Parties.

Testing the new system; the leading players have done their homework
In the pre-settlement process, the changes that CLS introduces are fairly straight forward, with the CLS matching process replacing the existing discipline of MT300 confirm matching. It is at the funding and settlement stage that there is a substantial change and a new discipline, with payments having to be made intra-day to cover account balances with CLS Bank. CLS set out a four stage testing cycle for all the shareholder banks wanting to take part from day one, with an extra fifth testing stage for a small group of banks that checks on the overall readiness for end-to-end testing.

The basic four stages are operational approval, technical approval, low-value payments testing (LMPT ) and a scripted live test (CSLT ). At the end of June, thirty-nine banks had completed the first three stages. Successful completion of the first two stages demonstrates that their operations are ready, that systems are connected to CLS and can submit trades. The third stage, LMPT, tests the newly required discipline of intra-day timed payments. This third stage of the testing revealed only a very limited number of teething problems and showed that the shareholders had prepared very well for this crucial new discipline. Overall, this is a hugely positive signal and a welcome one at that, after the many delays and great front-office cynicism that the project teams have had to endure.

Important Points for the start of live trading

Standing instructions. The integrity of static data can either be the root of all evil or the source of effective STP. There are several important things that the front-office needs to pay attention to. Firstly, in the FX processing chain, the relevant part of the systems need to be aware of who is CLS eligible and secondly, the correct BIC code needs to be captured. Straight Through Processing, STP, is achieved by rules and standards. In CLS processing, the matching rules look at the exact 11 character BIC's submitted.

There are some very compelling reasons for all participants to designate a temporary "CLS Control Czar" in the front or middle-offices during the early stages of live trading. Firstly, cash flow and funding will need extra scrutiny in the opening weeks. There will be "in" trades and "out" trades and potential for a funding imbalance. The Settlement Members have to look closely at their positions on value date minus one, take into account the expected influence of . the "In/Out Swap " process anything that causes a mis-match of trades, as well as the advised intra-day limits advised by the nostro providers.

Secondly, all banks will have to look closely at their "unmatched trades" in CLS. In the initial phases, it is highly likely that there will be a high

mis-match rate. Potential causes of this will be incorrect BIC information, as well as lack of clarity on the timing of the start for different branches and subsidiaries. CLS is working to ensure all participants have accurate static data and contact data available from the start. Achieving a high first pass matching rate in the early stages is essential for several reasons. Firstly, if the matching rate is low, back-offices will be confronted with a major challenge to monitor all the exceptions and re-book. Secondly, CLS will be charging for cancellations.

Reducing and Re-Allocating the Credit Lines
Eliminating settlement risk is what CLS was built for and it will do this. So all CLS participants, whether Settlement Members or indirect participants as so called Third Parties, should be changing their risk monitoring systems so that CLS trades are not charged against the settlement risk line. The next most important step and the key one to deriving benefit from CLS is monitoring activity to see where lines can be reduced. A key component of the lines used by FX desks today are the lines for so called "Electronic Dealings Systems", i.e. EBS, Reuters and FXall. A typical approach by a credit department is to treat the lines in the EDS systems as dedicated and fully used at any time, with CLS all participants have the opportunity to reduce lines and then to re-allocate to other businesses.

Third Parties; why are they important?
A Third Party is the CLS market's term for an FX market participant that will access CLS by buying services from a Settlement Member. The Third Party market is of huge importance if CLS is to become an ubiquitous standard for FX settlement. The volume of activity between these Third Parties and the Settlement Members, as well as amongst themselves is at least as significant as the volume of trades purely between the Settlement Members themselves. Analysis by CLS indicates the latter to be about 90'000 trades per day with the Third Party market accounting for another 140'000 trades per day (see figure 1: Total FX Market Size).

Back-offices in the securities world have long faced the problem of managing domestic settlement v. Euroclear or Clearstream. The FX world with CLS is no different. FX operations managers and funding desks will have an easier time, and by implication lower costs, if there is just one standard. Secondly, the Third Party market is a key factor in enabling CLS to drive costs down to the target level of $1.50 for all. It is worth noting that this is below the price of a settlement in FXNet today, with the added benefit of a single funding position and wider participation.

Third Parties; will they take part, why and when?
While we have all been waiting for CLS to be ready, the Third Party market has not been idle. We have witnessed the usual groupings associated with diffusion of any innovation. Figure 2: Typical Market Evolution, shows a commonly accepted view. "Pioneers", a limited number of banks shouldn't be superscripted, service provider selection and in a very few cases, implementation and testing. The prime driver for these banks is the same as for the Settlement Members; they know their regulators have an expectation that they should participate and they want to be ready.

Additionally, there are banks, such as Brown Brothers Harriman and WGZ, who have a leading role in their respective markets and want to show that they adopt a leadership position in changing markets. Our own estimate is that there will be an absolute maximum of twenty pioneers willing, ready and able to start before the end of 2002. The "Early Adopters" are those that are now ready to make a decision on a provider. They have done the research, asked the questions, in many cases sent out RFP's and analysed responses and are now down to a short list of two or three providers.

If we assume that their aim is to start in Q1 2003, then these decisions need to be made now. Our experience of working with Third Parties is that at least seven months are needed between making a decision and being ready to go live. If CLS can get its directory service up and running, then Third Parties will be able to separate the preparation stage from actually going live, by selecting a starting date based on what the market is doing.

The next group of entrants will be the "Early Majority". These are the banks that will set their sights on joining in Q2 / Q3 2003. Our experience shows that there is widespread awareness, interest and willingness to join amongst Third Parties. There are very significant numbers of banks that could be classified as early adopters. These range from the "might have been settlement members" to the leading banks in each market place. There is also an encouraging number of banks that we would classify as "Early Majority"; these banks have been gathering information and are now likely to increase the pace of this activity.

In continental Europe, some banks prefer an extensive information gathering process to the traditional RFP process that is common in the Anglo-Saxon world. An important consideration is also Basle II; banks are becoming increasingly aware of operational risk and the need to prepare. Going forward, it is not unreasonable to expect the use of CLS settlement to have an impact on the calculations. Based on CSFB's own analysis, we should expect the typical market evolution dynamics and statistics to apply.

Multi-Currency Nostro Services; The Killer Application in the CLS Market?
CLS leads to more nostro accounts. Certainly, this is true when a Settlement Member is first chosen. Increasingly in our contact with clients, we are seeing a change in the nature of clients' questioning. CLS functionality and mechanics are well understood. Now, we find banks are curious about multi-currency capabilities. Two aspects are in demand. Firstly, multi-currency credit limits. Potential Third Parties want one fungible limit that works in any currency, a payments service that nets all longs and shorts, as well as a service that does not have the complex Pay-In schedule requirements imposed on Settlement Members by CLS.

Secondly, multi-purpose accounts are in demand. Banks are looking for a service provider that can provide not just CLS settlement, but a payments service for commercial and treasury needs too. They are asking for a nostro with full SWIFT support in every currency, taking a long-term view that they will switch to one-stop shopping, buying multi-currency payment services in the same way they buy a global custody service on the securities side of the business. This is a seminal development in the FX market; we have seen the same trends in the securities business and with the current market conditions and pressure on costs, this "outsourcing" approach offers both opportunities for the creative service providers, as well as for the Third Parties.

CSFB CLS Project Team

LMPT: Low Value Payments Testing. This is a series of tests using live production systems where the banks are required to prove that they can instruct payments and move funds on an intra-day basis in accordance with a strict timetable, the so called "Pay-In Schedule". The process is based on the standard SWIFT MT202, with special annotations for timing requirements

CSLT: Continuous Scripted Live Test. This is an end-to-end test from trading through matching to settlement.

BIC: Bank Identification Code, this is an eleven character alphanumeric identifier. For example CRESCHZZ80A

In-Out Swaps: A special funding procedure that only affect the Settlement Members. Essentially an FX swap is done with one leg in CLS and the other outside. same day value with no swap points. At the expense of leaving some settlement-risk in the system, liquidity risks are reduced.

For more information contact Olaf Ransome, Head of Product Development & Support
Transaction Services & Solutions
Tel: 41 1335 2059, olaf.ransome@csfb.com


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