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In its initial form, CLS will have a significant impact on only a part of shareholders FX activities

There is every reason to be optimistic that CLS will finally go-live in 2002. Early 2002 is the appropriate time to ask the question: "What next or what else? Quo vadis CLS?" CLS's shareholders have made a considerable investment; it is essential that opportunities to leverage it are explored.

In its initial form, CLS will have a significant impact on only a part of shareholders FX activities. CLS as planned, will only affect the Bank-to-Bank (B2B) portion of shareholders' FX activity. This is only part of the volume, as Figure 1 shows. Clearly the gross value of the B2B activity is very large indeed and CLS participants will benefit greatly from the elimination of settlement risk. Indeed, they should also benefit from potential reductions in their FX processing costs. Figure 2 shows a typical FX processing cost structure and where CLS delivers benefit. Two important features are worthy of note. Firstly, the client business (B2C), which represents over 45% of all activity, will not immediately benefit from CLS. Secondly, B2C activity is fully 25%(i) more expensive to process than B2B activity.

In addition, what is not obvious from the data is that at least initially, CLS splits settlement liquidity and adds to the cost of cash management. CLS is an industry utility and as such it will not deliver compelling benefit to shareholders or stakeholders unless and until it is the default market standard for post-trade FX processing and settlement. CLS shareholders have painted an optimistic picture of the so-called Third Party market for CLS services. Without reaching out to include the B2C business, there will not be an ubiquitous standard.

Do corporates want CLS; do they see value in taking part? FX activity for corporates is often small relative to the asset base and risk is limited by restricting the number of counterparts and extensive use of netting. A typical treasury manager is less concerned with Herstatt Risk than with STP and standards, such as TWIST(ii) and its ability to drive internal efficiencies, as well as access to SWIFT are the priorities. CLS in its current format does not deliver any compelling benefits to a corporate. As CLS executes its ramp-up, it is possible that the sell-side market makers may try to force CLS settlement on the buy-side Treasury Centres, perhaps citing it as the industry standard. This might succeed, though more likely the buy-side would be interested in a structure that offered the prospect of easier to obtain and higher rates of STP.

FX as a product has an almost totally transparent market with razor-thin profits. It would be no exaggeration to describe the market as a practical example of the "theory of perfect competition", so beloved of economics teachers, with no market participant able to increase prices and profits unilaterally. Inevitably, this forces the sell-side market makers to focus sharply on the cost side of the P&L. Today, the inter-bank market is highly automated with a very satisfactory level of low-cost STP processing. It is the client-related business that still requires the greatest effort, with market makers investing huge amounts of resources to confirm trades, confirm SSI's(iii) and resolve reconciling items with the buy-side.

So, in the FX business, the buy-side wants greater efficiencies from higher rates of STP and the sell-side needs to reduce costs, which requires higher rates of STP and greatly simplified processing.

There are basically two principle cost points that will impact the client; A.funding complexity, B.systems complexity. Funding complexity is increased through the addition of nostro accounts with the Settlement Member.

CLS offers an FX trade settlement process closely resembling the DVP process that is commonplace in the securities markets. In GSTPA(iv), the securities markets have a workable STP model that serves the entire market and will shortly go live. Swapswire offers a similar functionality for interest rate swaps. Figure 3 "GSTPA for FX" shows what an STP utility for the FX world might look like. There are several important features that would be required to add significant value for the market participants:

The sell-side would inform the client of the trade via the utility and request an on-line affirmation, or both sides could instruct. In either case, the delay and expense of exchanging confirms and making phone calls is eliminated. This could easily be expanded to include block trade allocation details.

Standard Settlement Instructions (SSI's)
Centrally stored SSI's or just-in-time instructions enrichment would guide the forwarding of the settlement instructions. Each participant would be responsible for its own data within an SSI central data store. The utility will route settlement instructions accordingly, either to CLS or to the relevant nostros. Trades processed in this way would be "locked-in" and no longer unilaterally revocable.

Direct Market Interface
Electronic trading platforms such as EBS or FXall, could be easily accommodated by providing an interface or API.

Finally, there is the issue of who would operate such a utility. Real value can only be added where there is widespread market adoption, which requires a market-owned solution. Aligning such a utility with any of the electronic platforms would be a mistake, given the fact that each platform represents an alliance between a limited group of market participants. Such a step might well inhibit adoption.

GSTPA is an industry-owned standard that has a workable model and in axion4, a partner to deliver the solution. Its focus though, is on the securities market. CLS has an industry-wide ownership, is focussed on the FX markets, but does not have the trade flow monitor technology that GSTPA has developed. Compelling arguments could be made for either. Perhaps in an ideal world, CLS would licence GSTPA's technology.

There is considerable scope for such a market utility to add value and help reduce costs. The sell-side would be able to affirm transactions rapidly, reducing back-office costs. An API from the utility would enable the buy-side to update its systems in real-time. Centrally stored SSI's would reduce everybody's administrative overhead in maintaining static data, as well as eliminate errors caused by non-current data. Immediate forwarding of instructions to either CLS or existing nostros would eliminate all the overhead of confirmation matching, as well as all delays caused by late instructions to nostro banks. Very importantly, by borrowing GSTPA's business model the FX markets would be able to support a shortening of value date to T+1 to keep pace with what will be happening in the securities markets.


"GSTPA for FX" vs. CLS core competencies
We believe that CLS has three core competencies:

1. The ability to get two parties to agree on the terms of a transaction

2. The ability to execute payment relating to the agreement based on the knowledge that there is agreement

3. Access to central bank funds

It is not essential that any expansion in CLS's activities utilise all of these competencies. The proposal above uses only two of them and has the potential to deliver significant and compelling benefits to shareholders.

The introduction of CLS will basically bring with it the opportunity to virtually eliminate settlement risk, but will not offer immediate opportunities to make significant operational cost savings. The FX industry would greatly benefit from the introduction of a market utility to integrate CLS and FX trading and processing systems in the areas of trade affirmation, an accelerated matching and settlement processes through the use of SSI's and ability to interface with a range of trading platforms.

Importantly for shareholders, "GSTPA for FX" offers an immediate and tangible benefit that builds on the FX related skills built up in the CLS project.


CSFB CLS Project Team

i} Source: CSFB London Branch internal cost analysis

ii} Treasury Workstation Integration Standards Team

(TWIST) is a group of 15 global companies driving XML-based standards that facilitate STP by effective integration of treasury systems with FX trading platforms. See www.twiststandards.org for further details

iii} SSI's: Standing Settlement Instructions

iv} Global Straight Through Processing Association

Contact: olaf.ransome@csfb.com

Tel: +411 335 2059






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