Gearing Up for CLS Bank

Continuous-Linked Settlement, a dream of the foreign-exchange community for years, may finally become a reality by the end of 2002.

The foreign-exchange community's initiative to create a Continuous-Linked Settlement Bank, which would remove settlement risk from the world's largest market (it is estimated that daily-FX turnover is $2 to $3 trillion), could be live by year's end.

CLS Bank is all about taking the risk out of transactions that typically range from $3 to $10 million. The fact that counter parties to an FX transaction are usually in different time zones means currency exchanges are often not settled for a number of days, during which time firms are in the dark as to when and if they will receive the funds owed to them. The growing rate of FX dealing by the world's largest financial institutions prompted the creation of CLS Bank.

Settlement risk is removed because participating firms will either directly (as in the case of shareholders) or indirectly (as in the case of third-party banks through shareholders) have a funded account at CLS Bank. Those accounts will be funded throughout the day, guaranteeing that parties to a trade are liquid enough to hold up their end of the bargain. If both parties have the necessary means to settle, then funds will be exchanged on a payment vs. payment basis, if not, the transaction will not settle. CLS Bank authorizes the central banks to pay out monies but does not move funds itself.

CLS Bank recently completed real-time, end-to-end trials in seven currencies with 11 of the banks in its pilot program. Those trials saw the banks handling settlements and payments in line with CLS-timeline requirements using the seven central bank Real Time Gross Settlement (RTGS) systems. CLS-ready currencies are: the U.S. dollar, Euro, U.K. Sterling, Japanese Yen, Swiss Franc, Canadian dollar and Australian dollar - the Swedish Krona, Danish Kroner, Norwegian Krone and Singapore dollar are slated for 2003.

Karen Peetz, senior vice president and business manager for global payments and cash management, The Bank of New York, says that BONY became a shareholder and pilot participant in CLS to support the 2,200 international correspondent banks it does U.S.-dollar clearing for.

BONY, she says, has designed its own front-end tracking software, which allows banks to see their FX positions, and also developed an implementation plan for linking BONY technology with a third-party bank's back office. Peetz says it's important for third-party banks to ask potential CLS conduits a few questions, such as: "Who can help me once I change my back office so I can interface with (a member bank) and, ultimately, to CLS? What tools do I have to monitor and manage my cash positions?"

Smaller banks, especially those which do most of their business in a currency not supported in the initial CLS rollout, will need help running a dual system - one for CLS bank and one to support their primary trading currency.

"You may want to get CLS capability while still trading mostly outside of CLS, so you get duality," she says. "We're going in and helping clients sort through that." Peetz says financial institutions should estimate a six to nine month implementation timetable.

The pilot trials are being followed by expanded shareholder trials (there are 65 shareholders, 39 of which will participate in shareholder trials), which will essentially consist of testing similar types of payments and settlement functionality. Stage after stage of testing, starting with systems-integration testing in April, has been required to gain regulatory approval from the Federal Reserve Bank of New York, which has oversight of the N.Y.-based CLS Bank.

Though CLS executives were not made available for comment, a spokesman says that, after a few well-publicized delays, things are getting back on track. The recent trials, he says, are to make sure firms can meet the extensive criteria required to "connect, submit, amend, rescind and acknowledge payment and settlement instructions." Also important, is to ensure adequate business-continuity measures are in place before a planned launch in the third or fourth quarter.

The recent testing, he says, showed "one or two issues that will be resolved," such as increasing the speed of problem "diagnosis and resolution."

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Removing Risk
The industry started to get serious about taking the risk out of FX transactions after the failure of Germany's Bankhaus Herstatt in 1974. The crisis occurred because Herstatt's license was revoked after it had received payments from counter parties so it could not make good on its end of those transactions.