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CLS and Liquidity Management:
New Challenges; New Tools


The Real Impact of CLS
"Fair is foul and foul is fair" as the three witches described the future to Macbeth. The same might hold true for CLS. While the long-awaited advent of CLS should do much to mitigate Settlement Risk and contain capital charges, other risks might become more pronounced.

n The large capital expenditures required to build the CLS infrastructure will accelerate the trend of consolidation in the correspondent banking market and will require a highly sophisticated level of operational risk management.

n Since multicurrency solutions will be concentrated in the hands of a few correspondent bank providers, customers will need to more carefully review the contingency plans of their providers.

n The critical need for timed intra-day liquidity will challenge existing treasury processes and could expose weaknesses in the current market infrastructure.

This article will focus on the third of these challenges; the liquidity issues the industry is facing and the tools emerging to manage the new risks.

Intra-day Liquidity Demands & Interdependencies
Intra-day demands are nothing new. The increased use of DvP in securities settlement already requires early morning funding of settlement positions. Payments to certain government agencies need to be effected by a specific time. In most instances these are handled on a manual basis. When CLS commences, direct participants in the new settlement system, known as Settlement Members, will be required to pay huge amounts into CLS Bank in the early hours of the day. Although CLS is not introducing "early morning funding," it is increasing the impact of it.

To better understand the new intraday liquidity management challenges in the CLS environment we have to take a look at the interdependencies of the participants. In the centre of the CLS universe stands CLS Bank International. Although CLS Bank has liquidity agreements in place with certain Settlement Members, it does not have any direct access to liquidity or any assets that can be used to generate liquidity. CLS Bank fully depends on its Settlement Members who must meet their scheduled pay-in obligations for the CLS settlement process to begin.

Most Settlement Members need Nostro Agents [repeat comment - we capitalise this elsewhere] to provide liquidity in the different CLS currencies. Although the individual Settlement Member has the obligation to meet its pay-in obligations to CLS Bank, the actual delivery of the funds depends on the Nostro Agent. Similarly, branches, subsidiaries and Third Parties are dependent on the Settlement Members who sponsor them in CLS.

The Essential Liquidity Management Problem
Liquidity is a measure of how well funding commitments can be met at the time they are due. In the CLS process there are two liquidity challenges. The first is to offset long and short positions across all sponsored participants (branches, subsidiaries, and Third Parties). The second is to meet the CLS funding schedule. CLS Bank will require pay-ins to be sent to them between 7:00 a.m. and noon Central European Time.

Because CLS Bank accepts only matched trades there is a natural offset of the long and short positions of each trade. However, this offset is internal to CLS, and CLS Nostro Agents of one currency do not benefit from this offsetting affect. A CLS Nostro Agent that has committed to make payments on behalf of two Settlement Members cannot just pay the net difference if one is long and the other is short. The Nostro agent has to consider each position separately and pay the short position first, as required by the CLS pay-in schedule, at a pre-determined time, regardless of when payouts are received from CLS. This is the root of the problem. We have a highly scheduled process of pay-ins and payouts that occur over a period of time.

In today's payment environment, incoming payments are the dominant source of intra-day liquidity, and therefore randomness is the standard. At any point in time on a given day, any requirement to pay out more than has been received via a clearing system has to be covered by central bank overdrafts. These overdrafts are collateralised (except in the U.S.). As the incoming payments are highly unpredictable, any specific intra-day pay-out requirement raises the amount of the central bank overdraft and therefore the collateral requirement. This means we now have a direct relationship between the value of timed payments and the required collateral and therefore the cost of settlement.

Very Large Pay-Ins
Early analysis of the FX data submitted by CLS Shareholders confirmed the suspicion that potential spikes in the net positions will require very large pay-ins. Although in some currencies the liquidity would be available and covered by central banks using available collateral (at a cost), it would be difficult to find available collateral for other currencies.

The problem? The advent of CLS will not change, the overall FX volume. However, in the pre-CLS environment FX settlements occur on settlement day when the liquidity is available and with CLS and its specific pay-in schedule there is a new timing issue. Liquidity cannot exist in two places at the same time; therefore the same funds cannot be credited in two accounts concurrently. Also, the cost of increasing the available liquidity in some currencies is prohibitive; in others, impossible. Therefore, shifting part of the net position to a currency settling later in the day may be the solution. The tool to deliver this intra-day movement of positions is the Inside/Outside Swap.

One Solution: The Inside/Outside Swap for an Intra-Day Movement of Positions
The Inside/Outside Swap is modelled after the EBA/Target Swap which is a mechanism for transferring Euro liquidity between the EBA's Euro System and TARGET.

The CLS Inside/Outside Swap mechanism results in the removal of large net positions from the CLS settlement system and therefore the CLS timeline which results in moving cash flow requirements to either earlier (AUD and JPY) or later times (NA and European currencies). The CLS Inside/Outside Swap is a same-day Swap in which one leg of the Swap settles inside of CLS in order to reduce the net position, and the other leg settles outside of CLS.

FX settling outside of CLS; is this not defeating its purpose? Although the I/O Swap introduces settlement risk back into the process, overall there is still far less risk than in pre-CLS times. Joint estimates by CLS and regulators are that only 2 to 3% of the pre-CLS risk is re-introduced. The I/O Swap is a voluntary arrangement among CLS Settlement Members. The efficiency of the Swap depends on the distribution of the positions among the Settlement Members and the credit lines they are willing to give each other. That is, Settlement Members must trade with a sufficient number of trading partners and must provide adequate credit lines to facilitate the volume required.

Another Solution: Today/Tomorrow Swaps
Not all Settlement Members have bought into the concept of the Inside/Outside Swap. A group of Settlement Members would prefer to keep all of their positions inside of CLS, and will elect to use Today/Tomorrow Swaps in order to manage their position on an inter-day basis. While the I/O Swap is executed at the same price, the Inter-Day Swap is performed at Swap points reflecting the interest rate differential of the two currencies involved. Depending on the size of the positions being swapped this can be a sizable amount. This explains why the proponents of the I/O Swap are mainly made up of the larger banks, and the supporters of the second solution are mostly smaller and midsize CLS Settlement Members.

Pay-In Calls and Uncertain Liquidity Demands for Settlement Members
Do both methods ensure liquidity demands resulting from CLS activity can always be met? On sunny days, yes. However, in crisis situations, both are still exposed to uncertain liquidity demands resulting from potentially high value pay-in calls.

Pay-in calls are a risk management tool provided by CLS Bank which ensure completion of the settlement processes in the event that a Settlement Member is unwilling or unable to meet its commitment in CLS. CLS re-calculates Settlement Members' net positions excluding the trades that have been sponsored by the "tardy" Settlement Member and thus reduces the internal liquidity benefit (netting effect) of the CLS system. This causes CLS bank to call for incremental pay-ins from Settlement Members on very short notice. These instructions are then passed on to the Nostro Agents who must have the liquidity available to send the funds to CLS Bank in compliance with the pay-in call deadline.

The Underlying Problem: Liquidity is Still a Local Event
It is perhaps worth noting the underlying problem that ultimately needs to be fixed. Despite globalisation and the interconnectedness of the financial markets, liquidity is still a very local event. The only way to raise CAD liquidity is in Canada through the central bank and through the instruments they are willing to accept as collateral. If the market is trying to manage real-time multi-currency liquidity demands using single currency processes, we will always have liquidity problems.

Eventually liquidity will need to be generated in a way that better meets the needs of the integrated markets. A group of financial institutions are examining the new challenges introduced by increasing inter-day liquidity demands and will propose to the central banks, better processes to generate liquidity out of available liquidity in another currency. A precedent was set during the Y2K preparations when central banks were willing to accept each other's collateral to ensure proper functioning of the financial markets.

The New Buzzword: "Cross Border Collateral Pool"
One concept the banks are considering is the Cross Border Collateral Pool. There are two variations of the Cross Border Collateral Pool. The Common Collateral Pool would utilise a mechanism by which securities eligible for collateral usage at central banks are moved intra-day from one central bank safekeeping account to another. Although technically feasible, a lot of central bank goodwill is required to manage each other's collateral.

Another method is the Common Cash Collateral Pool which would involve the intraday movement of cash balances in one currency from one central bank to another in order to obtain liquidity in another currency. This method might be an easier one to manage than the Common Collateral Pool.

This example illustrates how a debit of one currency in one account can be used to credit another currency in another account. It shows how GBP liquidity is generated using USD liquidity.


n A Settlement Member needs 1 billion GBP.

n He has the equivalent amount of USD sitting in a Federal Reserve account.

Possible Process

n The USD is moved to the Bank of England's USD account at the Federal Reserve.

n The Bank of England grants the Settlement Member an overdraft of 1 Billion GBP backed by the Cash collateral in USD (after applied haircuts).

n The GBP intra-day overdraft is transferred from the Bank of England back to the Fed before the close of business in the UK.

n The USD is released back to the Settlement Member for further use in the USD processing day.

Such a mechanism would allow a quick response to incremental liquidity demands while using existing central bank channels.

Liquidity and the Nostro Agent
Generally speaking, Nostro Agents rely on overdraft lines from the central banks. Nostro Agents can also pledge collateral to central banks or make use of the Common Collateral Pool. Nostro Agents who are also Settlement Members can also use the I/O Swap to reduce their short positions.


n Settlement Member A is also the GBP Nostro agent for Settlement Member B in GBP.

n In the CLS system, Settlement Member A is long 750 million GBP and is short 1,000 million USD.

n In the CLS system, Settlement Member B is 500 million GBP short and 700 million USD long.

Possible Process

n As a Nostro agent, Settlement Member A would have to make hourly payments of GBP according to CLS Bank's pay-in schedule on behalf of Settlement Member B.

n Through the I/O Swap process, A could bring B's position inside of CLS by entering into a same day Swap in which A sells GBP 500 million and buys USD 700 million from B settling via CLS Bank, and B sells GBP 500 million and buys USD 700 million from A settling outside of CLS Bank.

n The resulting net positions in CLS would be GBP 250 million and USD (300) million for Settlement Member A and GBP 0 and USD 0 for Settlement Member B.

n Settlement Member A's internal CLS liquidity has been used to satisfy B's CLS bank commitments.

Please note that in addition to the standard pay-in schedule, pay-in calls could impact such a liquidity strategy.

How the Various Tools Stack Up
All liquidity tools discussed have one thing in common. They attempt to solve the timing problem associated with cross-currency intra-day liquidity needs.

The I/O Swap might not be the ultimate solution to the problem but it does provide some relief and makes the numbers more manageable. Certainly, in the short term, Swaps seem to be the only feasible solution.

Longer term, more innovative solutions, such as The Cross Currency Collateral Pool, may be the answer. During this time of increased globalisation a logical next step would be to use an excess in one currency to cover a deficiency in another. The Cross Currency Collateral Pool is a more elegant and general solution to the liquidity issue as its applicability is not restricted just to CLS. However, support is needed by the central banks to move this new tool from concept to reality.

Only experience will tell if these tools are effective enough to manage the liquidity demands introduced by CLS. Central Banks are certainly aware of the issues and have supported the I/O Swap concept. Ultimately the market will need to make a stronger case if we are to achieve a more integrated solution.

CLS is a trademark of CLS Group Holdings (incorporated as CLS Services, Ltd.)

Michael Knorr
Global CLS Product Manager
Citibank e-Business.

Michael is based at the Citbank e-Business global office in Stamford, Connecticut.

Readers wishing to obtain further information about Citibank CLS Settlement Services can contact michael directly at + 1 203-975-5067 or

e-mail: michael.knorr@citi.com



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