CLS Designated as Systemically Important by FSOC

The Continuous Linked Settlement Bank International (CLS) has been designated as a systemically important financial market utility (FMU) by the US Financial Stability Oversight Council (FSOC).

CLS, which is owned by its participant members, including 73 major financial institutions, is one of the settlement facilities underpinning the orderly operation of the foreign exchange (FX) market. Counterparties in an FX transaction reduce settlement risk through CLS, which acts as an intermediary between both, guaranteeing simultaneous payment of currency at a specified point in time.

The designation by the FSOC is due to the Dodd-Frank Act in the US, which authorizes the regulator under Title VII provisions to determine FMUs. These are usually facilities such as payment systems, securities depositories or central counterparties, which are deemed critical to the operation of the US market economy.

The appellation, it is assumed, will engender higher risk management requirements and reporting obligations for the institutions designated as such. This ties in with other major regulatory pushes, such as the Markets in Financial Instruments Directive (Mifid) in Europe, all of which have the reduction of systemic risk to financial markets as a core objective.

Herstatt Risk
CLS as a body was essentially born from the collapse of Herstatt Bank in 1974. German regulators forced the bank into liquidation on 26 June of that year, however, before that happened a trade between Deutsche marks and US dollars had been initiated, with the marks being released to Herstatt before liquidation, but the dollar reciprocal scheduled for settlement later. The counterparty banks, suddenly trading with a failed entity, never received their part of the trade.

The designation by the FSOC is due to the Dodd-Frank Act in the US, which authorizes the regulator under Title VII provisions to determine FMUs. These are usually facilities such as payment systems, securities depositories or central counterparties, which are deemed critical to the operation of the US market economy.

"Everybody knew what they were lending Herstatt, and presumably what they were willing to trade with them," says Jonathan Butterfield, director of communications at CLS Group. "I think the big surprise for everybody was just how much that bank had managed to secure from the industry. It had lines with everyone, so when it went bust, an awful lot of people were standing in line, waiting for the administrators to give them money, which didn't happen because there was virtually nothing left."

The second factor in the birth of CLS was the growth in the value of the FX market. During the Nineties, the daily turnover had reached $2 trillion (by contrast, now, the estimated daily average volume is around $3.8 trillion, making FX the largest capital market in the world by that measure), and various settlement cycles meant that the value-at-risk wasn't just limited to one day, but several. Regulators at the New York Fed, so the story goes, told banks that this was a problem that needed to be fixed, or it would be fixed for them.

"So, the banks sat down and asked what they were going to do," says Butterfield. "They worked through three different models on how to solve the problem, and decided that the one that we currently operate was going to be the most effective for everybody, but there were a lot of compromises. Despite the fact that this is a simple product, the actual processes that each bank uses can be quite substantially different. You're right down into the guts of this ─ there's a risk component to it about executing a trade along credit lines, and how it gets flagged up and approved, then where it goes in terms of the positioning systems so the bank recognizes that this deal at that price is part of its ledger, and then there's the processing of payment instructions and the final settlement, generally two days later. That process is different [between banks]."

Too Big To Fail
After the process was finalized, however, adoption was relatively swift, particularly with the boom in electronic trading within FX that is still ongoing today. CLS opened its doors in 2002, almost 30 years after the failure of Herstatt, with the group comprised of CLS Bank in New York, the entity designated as an FMU, and CLS Group. At this point, CLS settles payment instructions relating to underlying FX transactions in 17 currencies, making it the largest system for multicurrency settlement in the market.

The decision by the FSOC, therefore, following a two-part evaluation process over several months, comes as no surprise. Further announcements are expected from the FSOC and other regulators responsible for implementing and finalizing Dodd-Frank in due course. As well as CLS, other institutions named as FMUs were the Chicago Mercantile Exchange, the Fixed Income Clearing Corporation, the Depository Trust and Clearing Corporation, the Clearing House Payments Company, the National Securities Clearing Corporation, ICE Clear Credit LLC and the Options Clearing Corporation.

The Bottom Line

• CLS is among eight organizations deemed to be systemically important to the health of the US financial system by regulators. These include clearing houses, payments and settlement systems, and central counterparties.
• Those deemed as such will likely be subject to higher risk management requirements and reporting mandates in the interests of systemic oversight.
• The FSOC, along with the Securities and Exchange Commission, the Commodity Futures Trading Commission and other regulatory exchanges is responsible for the designation, as part of the Dodd-Frank Act.
• CLS aims to eliminate settlement risk, or Herstatt risk, in FX markets through simultaneous settlement of trades. It supports underlying FX transactions in 17 currencies, and is owned by a consortium of 73 financial institutions.