The Undemonstrative Hero? CLS at 20

One of the more important infrastructures in the FX industry has turned 20 – Colin Lambert takes a look at the impact and influence of CLS over the two decades, and also the service’s future

Talk to just about anyone at CLS for a period of time and the word “resilient” will come up, and it is probably this word, above all others, that describes what the service has brought to the FX market over its first 20 years of existence. Through some of the most challenging times the FX industry has ever faced, CLS has always been resilient, and ensured the world’s largest financial market has functioned effectively, no matter what the circumstances.

The demand from regulators that the FX industry create an effective method and process for mitigating settlement risk emerged in the wake of the collapse in 1974 of Herstatt Bank in Germany, which closed its doors halfway through the banking day. This meant it had received Deutsche marks from FX counterparties, but did not pay the US dollars out, and it is perhaps fitting that the event that brought the value of CLS home to FX market participants – especially in the front office – was the collapse of another bank.

The demise of Bear Stearns and Lehman Brothers were the headline acts of a period of high uncertainty in the global economy in 2008, with banks in several countries seemingly on the brink. This saw the functioning of the FX market, a critical mechanism in the global economy lest we forget, severely challenged.

“Our institution had serious internal discussions about whether we would continue to settle trades, or at least whether we would wait until the last possible moment,” recalls the head of a foreign exchange trading business in London. “We didn’t want to trade certain currency pairs if it meant we had to pay out before receiving, because there was such an air of uncertainty as to whether the counterparty would be there by the time it came to pay us. You just didn’t trust anyone, and looking back now it’s frightening how close we came to pulling out of the FX market.

“If I am being honest, prior to Lehman we thought CLS was an expensive white elephant,” the FX head adds. “There was no such thought after that – our perception swung 180 degrees. I don’t think the market could have functioned effectively without it.”

Resilience, along with safety, robustness and security have been watchwords for CLS from the start, indeed the false start endured by the service in 2001 was largely a result of understanding the importance of getting it right. That said, as John Hagon, chief operating officer of CLS observes, “Going live was about establishing a service, and it was an imperfect one at that time, in an imperfect world. The key was being risk-aware and measured in our approach, the challenges were less about speed to market and more about understanding what it was we were solving for and the design of the solution.”

“If we are to solve the challenges facing the industry, it has to be done collaboratively and with a view to building resiliency in the entire ecosystem.”
Marc Bayle de Jessé

As well as a delay, CLS also suffered a period of uncertainty about funding of the business in the run up to launch. “There was a period when we weren’t sure how it was going to work out,” recalls Hagon. “But the regulators and central banks intervened to ensure the banks continued to support us. That was crucial and demonstrated how serious the authorities were about making the FX market safer.”

A launch meant CLS could focus on making the “imperfect” service what it needed to be – perfect – and again resiliency was a big driver, thanks to lessons learned. “We invest in our operational and technology resilience every year. Most recently we replaced our settlement platform, which was a major undertaking. We gave it a complete refresh to bring it up to modern standards,” says Hagon.

“We continue on that journey by looking to get in front of problems,” he adds. “We have an InfoWall, a command centre for want of a better phrase, that provides predictive analysis based upon what ‘normal’ looks like. This highlights anything out of the ordinary, including threats to funding or settlement on a given day. This allows us to mitigate any problems ahead of time. It’s just another example of how we continue to invest.”

CLS has, to a large degree, flown under the radar throughout its 20 years. As noted, there were doubts about its value and its cost in early years, these were dispelled during the Global Financial Crisis, and since then it has become, as one senior FX salesperson observes, “part of the furniture”.

This low profile is reflected in two facets – the first and most important is that CLS has done exactly what it was designed for, mitigate settlement risk by smoothly settling trillions of dollars-worth of payment instructions every day. The second is how Project Convergence, the re-platforming of CLSSettlement, barely registered in the industry.

“Convergence was a major undertaking – to completely re-write your infrastructure is not something you do lightly in any organisation, especially one so critical to the FX ecosystem,” says Tom Barkhuff, chief information officer of CLS. “There was a huge amount of work and rigour that went into the project – which was, incidentally, the smoothest I have ever been involved in – but the result is we now have our own application.

“Owning the asset means we are able to enhance and build on the technology and create our solutions that meet client demand,” he continues. “The new platform is resilient, reliable and flexible – it’s probably the most advanced piece of software in the FMI industry from that point of view. This means we are able to consolidate our other services on it, and that is the roadmap we are working to.”

“To completely re-write your infrastructure is not something you do lightly in any organisation, especially one so critical to the FX ecosystem”
Tom Barkhuff

It is not only about renewal, however, for Barkhuff also explains CLS is creating a new hosting environment. “This will see us upgrade our co-hosting kit, improve our toolsets and management of them, as well as further improve our resiliency,” he says.

Growth Engine

There is a second word that could be used to describe the influence of CLS in the FX industry: growth. Not just as a business, but as a driver of increased turnover more generally.

In 2001, the year before the launch of CLS, daily FX turnover was $1.2 trillion. Roll forward 21 years and it sits at $7.5 trillion. Clearly not all of this has been driven by CLS alone, automation more generally has helped, but the operational savings effected by the service have played a role – nowhere more so than in the multilateral netting facility.

By calculating the net funding required of each settlement member on a multilateral netted basis, CLS says it can reduce the cash required to settle trades dramatically – it observes that about 96% of the cash that would otherwise be required for settlement can be redirected to other business operations. Additionally, settlement members can access a liquidity management tool, in/out swaps, which further reduces the funding requirement to the 1% often cited by CLS.

The opportunities presented by this cash management efficiency are not lost on FX market participants. “The regulators want to make the market safer. And while you can argue they are getting it wrong in some areas, the one area that has had a major influence is CLS,” says a senior FX banker in New York. “The cost of doing business just continues to rise, and while CLS is a cost, the net effect is to allow us, and many like us, to do more business. I wouldn’t say we look at any of our counterparties through the prism of a potential failure, but we do look at them through a cost lens, and it has become costlier to do business – to the degree I would argue it is almost impossible to envisage the FX market at the scale it is without CLS.”

Certainly while there is a macro-economic and automation driver of growth in FX markets, CLS can be seen to play a role – after all FX swaps, a key (and costly) business, remains largely unautomated, and it has grown from $646 billion in 2001 to $3.8 trillion in 2022, almost a six-fold increase. Likewise, outright forwards, another largely manual market, has grown almost 10 times to over $1.1 trillion per day.

“I would say CLS’s influence is only increasing in terms of overall market growth,” says the FX trading head in London. “It’s probably fair to say it reflected the broader growth of the market for its first 15 years and then as regulation played a bigger role, so too did CLS in helping maintain volume growth.”

“In terms of assets under management, we now have more than 75% of asset managers settling on CLS, and we are very focused on bringing others on board as well”
Lisa Danino-Lewis

This is a point reinforced by Lisa Danino-Lewis, chief growth officer at CLS, who says, “If you look at the growth of the FX market over the last 20 years you start to see the value that CLS has added. I don’t think that growth could have happened without CLS enabling firms to trade more freely.

“The buy side wouldn’t trade outside of their custodian, for example, because they were worried about settlement risk,” she continues. “CLS has enabled them to broaden their sources of liquidity and enabled best execution. There is an underlying value that is hidden from much of the market because they don’t see it day to day. People only think settlement risk if something goes wrong, but mitigating it can really help facilitate more trading.”

It is not only in the broader market that CLS is growing, of course, its own business continues to push ahead. Since 2019 CLS volumes have grown by 10%. In the first half of 2022, it was settling an average daily value of $6.5 trillion, and at the end of 2021, it hit a new daily record with $15.4 trillion settled on 15 December. Its cross-currency swap business has also grown, as has CLSNet, which hit a new daily peak of $200 billion on 21 September 2022 – just days after the actual 20^th anniversary of CLS’s launch.

“We look to new growth, and the last two years has seen a shift away from growth among settlement members, which had been running at 35-40% of our new growth,” explains Danino-Lewis. “That sector is now perhaps 5% of our new growth and has been replaced by third-party participants, especially in Asia-Pacific.

“Asset managers have also been a growth story,” she adds. “In terms of assets under management, we now have more than 75% of asset managers settling on CLS, and we are very focused on bringing others on board as well. The custodians are helping here, because bringing their clients into CLS enhances their own operational efficiency.”

Looking Ahead

Much was made of the Bank for International Settlements (BIS) report in 2019 that highlighted the large outstanding notional value not settled on a payment-versus-payment basis. In its initial calculations, the BIS estimated the value to be in excess of $8.9 trillion per day.

There have been doubts expressed in the industry over the importance of this data, and CLS itself points out that a large proportion of the trades included by the BIS are internal within an organisation and therefore unlikely to carry systemic settlement risk. There are, however, some areas where there are gaps and this will be a focus for the coming years at CLS.

“Instantaneous settlement is not a panacea – in fact it’s difficult to imagine the FX markets being able to operate as they do today without highly reliable multilateral netting at scale”
Keith Tippell

“We have three main areas of focus: risk mitigation for other currencies not yet eligible for CLSSettlement; same-day settlement; and helping members seeking to ease the pressure of regulation, in particular for FX derivatives,” explains Marc Bayle de Jessé, CEO of CLS. “Firstly, looking at currencies not settling in the system – this is where a substantial systemic risk lies. We estimate that CLS covers up to 90% of what’s been traditionally deemed settlement risk for CLS-eligible currencies, while the market is fully exposed on other currencies, with the largest gap being trades with the RMB.

“In our existing settlement service, it is important that CLS is able to provide access for that remaining 10% of volume in some fashion, to bring some risk mitigation into play,” he continues. “We understand certain participants choose not to connect. They can, however go through our settlement members who offer third-party services, and we have over 30,000 legal entities who are accessing CLSSettlement in this way. This covers a lot of the market; but there is a long tail, which is complex to address.

“Onboarding additional currencies is a complex and regulatory exercise,” he adds. “We need the legal finality in the law of that currency as well as international law. That legal and regulatory process takes time, as the pace of onboarding is primarily driven by local authorities and the preparedness of market participants.”

Filling the risk gaps has been the driver of a lot of product innovation at CLS in recent years – not least the launch of CLSNet, which seeks to capture additional currency flows outside of CLSSettlement. “CLSNet was built to solve the problems that can be solved today,” explains Keith Tippell, chief product officer at CLS. “For those currencies outside of CLS it centralises the process, captures the trades, and enables bilateral netting calculations. The volumes and number of users in CLSNet are growing – volumes recently surpassed $100 billion per day, which underscores the network effect of the product. What we are now looking to do is add functionality which will further mitigate risk, with the ultimate end goal being PvP.”

A second product evolution, and also a point of focus for Bayle de Jessé, is same-day settlement, something covered by CLSNow. By his own admission, the take up has been slower than expected; but against the background of a darkening macro-economic picture, liquidity will inevitably become constrained, and opportunities exist for CLSNow. “We are looking at ways to adapt the service,” Bayle de Jessé says. “Liquidity will become more expensive, and CLS can help mitigate the risks involved.”

The third key area is one that is taxing the minds of many in the FX industry – the creep of regulation. “More members are looking to optimise capital via central clearing or other methods,” explains Bayle de Jessé. “CLS is part of the solution – we already have CLSClearedFX, which works with LCH ForexClear – and we are partnering with other firms in the ecosystem around services like optimisation.

“We are also talking with other providers to see if an adaptation of our service can help the industry,” he adds. “If we are to solve the challenges facing the industry, it has to be done collaboratively and with a view to building resiliency in the entire ecosystem.”

One area not on CLS’s agenda at this time involves the new technology coming out of the cryptosphere. “The problems we are solving for are not about technology, they are more about scaling a solution,” argues Tippell. “The ability to work on a blockchain-type solution doesn’t move the dial because CLSSettlement is an immutable record of what is going to settle anyway. CBDCs [central bank digital currencies] can change things, new technology won’t.”

Tippell also points out that speed of technology is not the key point, “It’s more about the robustness,” he says. “Instantaneous settlement is not a panacea – in fact it’s difficult to imagine the FX markets being able to operate as they do today without highly reliable multilateral netting at scale. There are of course very niche cases, for example where an entire end-to-end securities lifecycle is digitised, where this could be a benefit, and maybe this is where CBDCs play a role.”

Reflections

As CLS embarks upon its third decade, it is fair to say that every time it has been challenged in its first two decades, it has met the challenge. As far as Bayle de Jessé is concerned, this is how it should be with any financial market infrastructure, but the effort involved is probably under-estimated by the industry. “We have to be at the top of our game every day,” observes Hagon. “If you want safety, soundness, predictability, security, resilience, repeatability and performance, then CLS is the port of call, and it takes a considerable effort to maintain those standards.”

There is a sense that CLS is still under-valued by the FX industry, not through ignorance, but more because it remains undemonstrative – it works steadily, and safely, in the background, doing what one senior banker terms “the un-sexy stuff”. In no way could the service be seen as a fast mover, but as noted, with speed comes increased risk (although Bayle de Jessé is proud of the fact that when the pandemic hit and CLS, like so many others, had to send staff home, CLS continued to operate normally).

“You come to CLS for certainty, predictability and something that does exactly what it is meant to”
John Hagon

The headline act for CLS’s first 20 years is inevitably the events surrounding September 2008, but it has been a steadying hand on the FX market tiller throughout – not least its role in maintaining a semblance of stability amidst the chaos and mayhem of the Swiss National Bank de-pegging in 2015.

Perhaps the last word on the first two decades of CLS should go to the man who has been there throughout – and more – John Hagon. “CLS does something good, makes a positive difference, every day,” he says. “When we enhance the service it has to be essentially perfect, and that takes time, effort, thought, scrutiny, governance, regulation and industry collaboration. Nothing we do in those circumstances is going to be quick – if you want quick, with the uncertainty and risk that goes with it, don’t come to us.

“What CLS provides is a service that helps the FX market operate smoothly and efficiently and that is fit for purpose, resilient and open for everyone to use, with a regulatory umbrella and legal framework around it,” he continues. “You come to CLS for certainty, predictability and something that does exactly what it is meant to.”