February 1, 2009 8:19 am

A little oasis of calm for currencies

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In the depths of the mid-1970s recession, a swathe of US banks was left out of pocket when Herstatt Bank, a privately owned German operation, was put into liquidation by German regulators.

The Americans had handed over dollars to Herstatt earlier that day as one leg of routine foreign exchange transactions; they fully expected deutschemarks in return a matter of hours later.

The actions of the German regulators rudely interrupted this process. The deutschemarks were never handed over and the phrase “Herstatt risk” became synonymous with settlement risk in the FX community, giving the Cologne-based bank far greater notoriety in death than it ever achieved in life.

The later collapses of Bank of Credit and Commerce International in 1991 and Barings in 1995 led to similar losses, but despite the turmoil currently roiling the banking industry – and
ever-rising turnover in
the FX market, some $3,200bn (£2,268bn, €2,424bn) a day according to the Bank for International Settlements – there have been no reports of similar mishaps this

This oasis of financial competence is largely attributed to the activities of CLS Bank, established by a consortium of global financial institutions in 2002.

CLS, which now settles 55 per cent of all FX trades, operates a payment netting system that virtually eliminates settlement risk by, in effect, acting as a trusted third party between the counterparties.

FX settlement risk particularly worries central bankers because the sums involved are large enough to potentially create systemic risk in the global banking system. The success of CLS has been such that some industry figures believe the problems surrounding clearing and settlement in the FX world have now largely been solved, although others believe there is still work to do.

The BIS said last year that, while significant progress had been made in eliminating settlement risk through the development of CLS, it was still concerned about the 45 per cent of FX transactions settled elsewhere.

The concern is shared in the very highest corridors of power.

Tim Geithner, the new US Treasury secretary, said last year in his role as chairman of the BIS Committee on Payment and Settlement Systems: “The financial services industry has made significant progress in dealing with foreign exchange settlement risk.

“However, more can and should be done to tackle remaining exposures and to guard against the risk of reversing the progress that has already been achieved.”

Bill Boss, global head of FX and money market operations at UBS, one of the banks that jointly own CLS, argues that part of the solution may simply be to expand the range of services CLS provides.

He suggests CLS could offer same-day settlement of trades such as dollar/yen, which is problematic due to the time difference between the US and Japan, expanding its current roster of 17 currencies and endeavouring to sign up more members.

“Getting a lot of customers on CLS is a good thing. Getting the remaining currencies on is a good thing,” he says. “When a trade or a currency pair or counterparty are not on CLS, that is when the fun begins. The industry does not have many ways around it.”

Jonathan Wykes, head of Advanced Execution Services, FX sales in Europe at Credit Suisse, believes cost factors have stopped CLS from increasing its penetration further still, particularly at a time when many participants are having to slice trades up in order to execute at the best price.

“The number of [deal] tickets is rising as people split their trades. It’s a very fragmented market, maybe you can do €10m at the best offer price, so do €10m times 10 venues. And with higher volatility, some market makers are in the market in smaller sizes. Liquidity has thinned out and spreads have widened.”

Greater take-up of bulking and netting arrangements before feeding trades into CLS could reduce charges, Mr Wykes argues, but this practice is currently frowned upon.

“A lot of people want to put their trades through CLS because it reduces their settlement risk and ultimately some of their credit risk as well, but the clients want to reduce the total cost of trading,” he says.

Most of AES’ trades do go through CLS but some go elsewhere, typically with a credit support annex or similar arrangement in place to reduce settlement risk.

Other operators may help fill gaps in the industry. LCH.Clearnet, Europe’s largest independent clearer, is working on a plan to start clearing FX trades.

Roger Liddell, chief executive, told the FT in October: “A lot of the risk is taken out by CLS but there are firms that are looking again at FX to see whether it makes sense to have a clearing offering as well. I think
it’s distinctly possible that FX will have clearing arrangements.”

Icap, the inter-dealer broker, also has plans to expand into over-the-counter post- trade services, potentially including FX. Both Icap and LCH.Clearnet declined to comment for this article.

Mr Boss offered a qualified welcome to the putative newcomers, saying: “There is potential for other vendors to get involved and sell their wares.

“We are hugely supportive of CLS but there is always room for a smaller, more nimble vendor to be involved.”

However, he warned the fragmentation of settlement and clearing activities could reduce efficiency. “CLS is all about multilateral netting, which is more efficient. When you start eroding that and putting trades here and there it erodes a little bit of value,” he warns.

“But it’s always good from a competition viewpoint to have other operators.”

In the interim, UBS has looked at the potential of establishing an escrow service to act as a trusted third party for its clients, says Mr Boss, although this initiative has been held back by issues around secrecy, fees and the legal structure, as well as technical details.

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