The End Of Risk

  • 18 Sep 2002
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By Tom Groenfeldt
September 2002
Institutional Investor Magazine

After repeated delays the foreign exchange market's CLS Bank is finally about to open. Can its owners recoup their costs?

For central bankers, financial industry regulators and the policy wonks who care about all that they do, June 26, 1974, marked the end of innocence. That's when midsize German bank Bankhaus Herstatt collapsed, unable to pay the tens of millions of dollars that it owed to correspondent banks in London and New York. If not for the quick response of central bankers, who assured the financial markets of an ample supply of liquidity, skittish bankers would have put holds on their international accounts, and global commerce would have ground to a halt. The Herstatt failure could easily have escalated into the worst banking crisis since the Great Depression.

Instead, much good came from the Herstatt incident. International electronic payment networks, notably the New York Clearing House's Chips system, revised their settlement procedures to guard against the contagion that came to be known as "Herstatt risk." The newfound emphasis on speed and assurance of payment influenced procedural reforms in the securities industry, principally the mid-1990s shortening of the transaction settlement cycle from five days after the trade date, or T+5, to T+3. And central bankers became increasingly adept at crisis management as they dealt with the debacles of Drexel Burnham Lambert, Barings Bank and Long-Term Capital Management.

Yet none of those initiatives over the past quarter century directly addressed one big component of Herstatt risk: the largely unregulated trading in currencies. Rampant speculation in foreign exchange brought Herstatt down. Had there been a disciplined approach to transaction processing and settlement -- enforced by a utility like Chips for banking or Depository Trust & Clearing Corp. for securities that would clamp down on institutions incapable of meeting their obligations -- Herstatt would never have happened, and contagion would not have been an issue.

Twenty-eight years later, the forex market is about to get that mechanism in the form of continuous linked settlement, to be managed by a New York_based entity, CLS Bank International. Owned by 67 financial institutions in 16 countries, the elite of international commercial and investment banking, CLS may just be the last link in the chain of assurances that cover what central bankers term systemic risk. "When CLS Bank goes live, the risk in cross-border payment-instruction settlement will be eliminated," declares Joseph De Feo, president and chief executive officer of CLS Bank.

How can De Feo be so bold? CLS will give the foreign exchange market something it has never had: a single coordinating point for settling accounts across multiple currencies. And in streamlining that process, CLS will reduce the time required for interbank transaction settlements, which today occur throughout normal business hours, to a five-hour window, simultaneous across all time zones. Centralization enables enforcement of market discipline. Time compression prevents an untoward event in one part of the world from having a domino effect, as Herstatt did when it failed in the middle of the European business day, wreaking havoc on the accounts of New York banks that had not yet opened.

Clearly, the forex market -- in which $1.2 trillion changes hands daily and a $20 million trade is merely average -- is ripe for continuous linked settlement, which will apply modern computing and communications to processes that have historically been fraught with hazards. Currency settlements, which today hang in a limbo of uncertainty over a two-day period, will be settled electronically at a determined time, reducing the costs of exception-handling and reconciliations. And as with Chips or DTCC, banks' liquidity requirements -- and loss exposures -- will be greatly reduced through multilateral netting: When settling their accounts each day, banks will have to disburse to counterparties less than 10 percent of their gross transaction amounts. In concept and promise, CLS has been universally acclaimed. "This is a fundamental change in the way that banking works," explains CLS communications director Jeffrey Manton. "The way payments are done hasn't really changed for hundreds of years."

If all goes as planned, CLS should be in full-scale commercial operation by year-end or early in 2003. The bank expects to handle up to 90,000 transactions per day from its current members. Because the shareholders account for 80 to 90 percent of the global forex market, CLS expects to control a similar percentage of interbank settlements.

"With the buy-in of the major FX trading institutions already in place, much of the risk in this market will be mitigated," concludes payments technology analyst Jeanne Capachin, a research director at Meridien Research, based in Newton, Massachusetts.

The big question now is whether CLS Bank can actually deliver on the promise of its systems and technology. Its track record has been, at best, spotty. Technical missteps and cost overruns plagued the venture for three years -- until the CLS board brought in De Feo, a former Goldman, Sachs & Co. and Barclays operations executive. He tightened management controls, persuaded principal technology contractor IBM Corp. to devote more people and resources to the project and launched a rigorous testing program now entering its final stages.

CLS is two to three years behind schedule, and bankers are eager to get it under way. They are keen to reap the rewards of risk reduction, and because they have collectively sunk more than $350 million into the enterprise just to get it to this unfinished stage, they'd like to recover their investments more directly by bundling together enhanced, fee-generating forex-related services for corporate clients and correspondents. "This is related to many other products that we offer to financial institutions. CLS would help us to continue packaging solutions and make the one-stop shop a reality," notes Jack Jared, global financial sector chief for Citibank E-Business, based in London.

Although the advent of the euro is seen as reducing forex demand -- because there are fewer currencies -- De Feo says that some banks expect the business to grow, and CLS will be integral to their plans. "We are seeing a number of players, like Merrill Lynch, expanding their FX teams," he notes. "The trend is for quite substantial volume to come from portfolio diversification and continued globalization."

But even the upbeat De Feo must be careful not to get too far ahead of himself. Only in July did CLS Bank announce the completion of its first "live trial" phase, involving 11 banks. "We still have milestones to reach, but no one in the market underestimates the significance of that step," says Suzanne Labarge, vice chairman and chief risk officer of Royal Bank of Canada and chairman of CLS Bank's parent company, CLS Group Holdings.

The live trial paved the way for expanded testing among all of the shareholder banks, which are awaiting approval from the Federal Reserve Board, CLS Bank's principal regulator, to officially open CLS's doors. "Pressure from central banks and regulators should ensure CLS's success," says Meridien's Capachin. But will bank participation alone vindicate CLS after its years of struggle?

"Once CLS gets off the ground, I think the banks will focus more on how they can recoup their investment, and that's going to be a challenge," says Kenny McBride, global capital markets industry manager for Microsoft Corp., which has been working with numerous CLS members and other software companies on the "plumbing" of foreign exchange settlements.

THE MARCH TO CONTINUOUS LINKED settlementment began in earnest in the mid-1990s, when the Federal Reserve and the other industrialized-country central banks that belong to the Bank for International Settlements in Basel, Switzerland, made clear that they wanted to get serious about forex risk. Their strategy had three elements: closer central bank involvement in cross-border payments, including a more precise definition of the "legal finality" of payments as well as a new standard, real-time gross settlement; credit controls at individual banks to limit their exposure to counterparty defaults; and private sector multicurrency settlement entities. The last point gave rise to CLS Bank.

"We made it clear that the supervisors were very much aware of the risks and would be watching the development of the risks," recalls a central bank official, speaking on condition of anonymity. "Supervisors explicitly adopted a set of guidelines for reviewing how banks manage FX exposure."

To the banks the message was simple: Reduce risk or the central banks would raise bank capital requirements to provide a firmer cushion against that risk. The Bank for International Settlements underscored that point in 1996 with "Settlement Risk in Foreign Exchange Transactions," a document dubbed the Allsopp Report, after the head of the task force that produced it, former Bank of England payment systems chief Peter Allsopp. Warning that the failure of a single bank could shake the foundations of the international banking system, à la Herstatt, the report called for improvements in forex processing and for greater cooperation between the public and private sectors in pursuit of long-term solutions.

In response, major international banks formed the Group of 20. One of them, Barclays, assigned De Feo to the project, and in June 1997 the G-20 announced the formation of CLS Services, a transitional organization that would develop a forex settlement infrastructure and eventually be absorbed within CLS Bank and its London-based parent, CLS Group Holdings.

CLS initially had no CEO. John Finigan Jr., a Deutsche Bank managing director who chaired the CLS Group board, in effect ran the company. Bank officers like De Feo contributed as part-time volunteers or were seconded from their employers for specific assignments. One, H. Clay Simpson of Bank of America Corp., was instrumental in CLS's 1998 membership drive, which attracted 40 banks from 14 countries.

With an eye to the multilateral settlement approach that had successfully reduced risks in interbank payments and in securities trades, CLS acquired two forex netting services, Echo in Europe and Multinet in the U.S. CLS also issued a request for information from vendors interested in building the core technology for continuous linked settlement.

IBM won the assignment, beating out a joint proposal by Electronic Data Systems Corp. and Logica and another from U.K. systems integrator Syntegra. IBM set a CLS start date of mid-2000, but the project went off track almost immediately. Some critics say that the pitfalls were inevitable given the haste with which CLS drafted its request for information. Others note that CLS itself needed stronger, more hands-on management than Finigan and his board of directors could provide.

But the most obvious failing was IBM's, which tarnished its reputation as a supplier to the banking world. Several of the payments technology experts that IBM had assigned to CLS left the company, morale sagged as deadlines kept being missed, and CLS's funding -- $5 million equity stakes from each of its member institutions -- dwindled.

With a crisis looming, Finigan called in a team of supportive bankers and outside consultants to try to right the ship. "We had to put together a package to ask for additional funds from existing shareholders," recalls one of the consultants who worked on the project. "It became clear there was no way to hold to the original timetable, and CLS didn't have funds to see them through that extended development period."

The group drew up a revised and detailed development agenda, business plans and cost projections, and in May 2000 each shareholder agreed to contribute an additional $1.6 million. They didn't need a lot of arm-twisting; central bankers and regulators signaled that CLS was a priority. But the missed deadlines and rising costs -- on top of the $350 million-plus that CLS Bank acknowledges investing in the enterprise, the banks have probably spent at least half again as much on their internal system preparations -- did not bode well.

Finigan strengthened management. Simpson, after retiring from BofA's treasury business, rejoined CLS full-time as executive vice president for relationship and product management. And Finigan recruited De Feo as CEO, who in turn added several others -- all former Barclays colleagues -- before 2000 was out: Rob Close as group chief operating officer, Anne Nethercott as director of operations, Sean Spence as chief financial officer and Sean Daly as program executive. (Finigan left Deutsche last year to become CEO of AIG Trading Group, and Royal Bank's Labarge became CLS chairman.)

"It was almost like starting from scratch. The board and the company had gotten embroiled in a lot of distractions," says De Feo, who inherited an organization in disarray, with a membership that turned board meetings into extended gripe sessions about how far the program had gotten off course. He didn't pull any punches: "The board, when I made my first report, was quite stunned at how serious things had become. It was a very daunting task to get all of the various projects and various activities into shape."

IBM took much of the blame, and De Feo and COO Close spent much of their time patching up the relationship and getting it back on course for a November 2001 launch. De Feo lobbied for support from IBM's top ranks. According to knowledgeable sources, even the Federal Reserve intervened, strongly encouraging IBM CEO Louis Gerstner Jr. to give CLS all that it needed.

Within months the tech giant had noticeably picked up the pace, dedicating an estimated 400 to 500 people to CLS. "IBM has lost a lot of money on this," says one observer. "But it is a flagship development in front of a critical client base. If they had pulled out, all of their clients were watching, so it would have been very painful." IBM officials decline to comment on the company's relationship with CLS Bank.

Despite IBM's rededication, getting CLS going still "took a lot longer than anyone anticipated," laments De Feo. He and IBM suffered the embarrassment of another postponement. One reason: De Feo's insistence that the infrastructure, which had to be built from scratch, had to be beyond reproach, and that the only way to assure that would be through extensive testing, which is ongoing. "Our technical and operational testing must meet the highest standards," De Feo asserts.

Technologists say that CLS has gotten past its many glitches, and they are confident that the launch really is imminent this time. Says Joseph Mazzetti, a corporate executive vice president at Jersey City, New Jersey_based Fundtech, a supplier of software to many of the CLS member banks and to CLS Bank itself: "We are overcoming the disappointments and finally moving toward a conclusion. The industry and the central banks want it to happen. The momentum is definitely there."

THE RATIONALE FOR CLS IS MUCH LIKE that of the Securities Industry Association's campaign to accelerate the equity settlement cycle from T+3 to T+1: The quicker and more automated the process of matching orders and moving the necessary payments and documents, the better it is in terms of risk reduction and operational efficiencies. Such conversions are costly -- so much so in the SIA's case that it recently decided to postpone the June 2005 T+1 deadline indefinitely. Instead, the SIA is promoting fully automated straight-through processing, or STP, which will make the ultimate transition to T+1 easier.

Indeed, STP is a top priority throughout the financial industry and in applications ranging from basic payments and letters of credit to complex financial instruments, not least foreign exchange. Forex processing is a bargain, and relatively easy, compared with the convoluted, back-and-forth routing of equity trades from pretrade to postsettlement and dozens of stops in between. Forex's critical central settlement piece -- CLS Bank -- seems certain to come in at a total cost of under $1 billion, well below the $8 billion that the SIA expected the U.S. securities industry alone to spend on T+1 preparations.

When T+1 was still on the drawing board, the forex world was under some pressure to figure out how to reconcile that with its T+2 customs. An estimated 30 percent of securities trades are cross-border, requiring offsetting currency trades. And at least 10 percent of foreign exchange transactions are securities-related. Ironically, the forex industry doesn't have to worry any more about creating any obstacles to T+1: It is now ready for T+1, well ahead of the securities industry.

"The difference with CLS is that it is final and irrevocable settlement within two hours, which is a complete change from two days," says communications director Manton.

Technically, CLS serves as a trade-matching engine along the lines of the Omgeo or Global Straight Through Processing Association services for securities transactions. In its short five-hour window, CLS gathers information on members' forex trades and moves funds as necessary among accounts on the books of CLS Bank, which is chartered under the Edge Act, a federal law governing foreign banking operations in the U.S.

CLS will initially handle seven major currencies -- U.S. dollar, euro, pound, yen, Swiss franc, Canadian dollar and Australian dollar -- and plans to add three Scandinavian currencies and the Singapore dollar next year. Banks can submit their payment instructions up to 6:30 a.m. Central European Time on settlement day. (If the instructions are for a forward contract, they can be submitted weeks or even months in advance.) CLS Bank provides banks an advance "pay-in" amount -- the total funding required across all currencies -- as well as payment schedules showing the net amounts they owe or will receive in each currency. CLS Bank expects to reduce 2,000 to 4,000 gross settlement positions to 18 or fewer payments per bank. The final settlement window opens at 7:00 a.m. in Europe -- and simultaneously at central banks around the world including the Federal Reserve, which will open for CLS transactions at midnight local time (6:00 a.m. in continental Europe).

Once a bank has sufficient funding to begin the settlement process, it pays net amounts into CLS Bank accounts at the respective countries' central banks. Between 7:00 and 9:00 a.m., members' payments move in and out of those central bank accounts, with the positions managed all the while on CLS Bank's books. The remaining three hours are devoted to closing and reconciling the net settlement obligations and, if necessary, unwinding the payments of banks that fail to settle their accounts.

"Versus where you are today, you'll require as little as 4 percent of the total payments to facilitate settlement," says De Feo. "That reduces the possibility of errors, reduces reconciliations and makes the use of nostro [correspondent] accounts more efficient. We think there will be some real, quantifiable back-office and treasury savings that will come through to our shareholders."

What's more, banks' currency positions are aggregated for settlement purposes. If, say, a bank is long on Swiss francs but needs the money to settle in euros, CLS Bank makes the conversion. "You don't have to have euros immediately available, and that helps in managing cash and liquidity," explains De Feo.

That all might be sufficient to sell CLS as a secure, risk-reducing settlement utility. But banks and technology companies also want to tap into the revenue-generating potential.

Besides selling systems and services to help banks connect to and take advantage of CLS, companies like Fundtech, SunGard Data Systems and Wall Street Systems are putting forex processing in the broader STP context, which is one of the few technology areas where financial institutions are spending money these days. And banks like ABN Amro, Citibank, Deutsche Bank, HSBC and UBS are packaging CLS-related services in their offerings to correspondent institutions and corporations. Citibank, for example, recently signed Germany's Westdeutsche Landesbank Girozentrale to use its CLS settlement service, and ABN Amro won the CLS mandate of Italy's Banca di Roma.

Banks could increase their forex income simply by charging for liquidity when it's needed -- though none have yet formally announced plans to do so. Explains Citibank's Jared: "If you are a settlement member of CLS, as we are, you must have sufficient liquidity at the times when payments have to be made. What was before an overnight loan is now going to be a six-hour loan or a four-hour loan or a two-hour loan. If, at 2:00 a.m., we have to make a payment of $200 million that overdraws our account at the Fed, we will get charged, and that charge will have to find its way back to the users of the product."

Also sensing new business potential are custodians, which handle foreign exchange transactions on behalf of asset managers. They have formed a working group headed by David Pilbeam, business solutions manager in London for Chicago-based Northern Trust Corp., to bring mutual fund transactions into CLS sometime next year. If they can resolve the complexities of mutual fund trades, the custodians could lower their costs while boosting fee income.

"The plain fact is that we have been manifestly unsuccessful at persuading clients to do their FX internally," says Pilbeam. "We have an obligation to provide best-practice settlement for our clients."

Says Fritz McCormick, a financial technology analyst at Boston-based research firm Celent Communications: "CLS isn't just seen as a stand-alone cost center. It is part of the overall push toward automation for decreased risk, lower costs and for driving new business through outsourcing and connectivity."

De Feo agrees that the commercial potential, more than pressure from central banks, regulators and risk managers, accounts for CLS's ability to stay the course and keep its shareholders on board. "A lot of people thought banks were doing this because they were having their arms twisted by central banks," says De Feo. "But you don't hold together a shareholder base of aggressive organizations like the ones we have just on the basis of threats."

How much revenue might CLS businesses produce? And will that be enough to keep the banks happy? No one can say until CLS Bank gets off the ground, and that's something that De Feo still has to deliver.

  • 18 Sep 2002

All International Bonds

Rank Lead Manager Amount $m No of issues Share %
  • Last updated
  • 17 Oct 2016
1 JPMorgan 310,048.18 1328 8.75%
2 Citi 285,934.48 1059 8.07%
3 Barclays 258,057.88 833 7.29%
4 Bank of America Merrill Lynch 248,459.06 911 7.01%
5 HSBC 218,245.86 884 6.16%

Bookrunners of All Syndicated Loans EMEA

Rank Lead Manager Amount $m No of issues Share %
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1 JPMorgan 29,669.98 55 6.95%
2 UniCredit 28,692.62 136 6.73%
3 BNP Paribas 28,431.90 139 6.66%
4 HSBC 22,935.49 112 5.38%
5 ING 18,645.88 118 4.37%

Bookrunners of all EMEA ECM Issuance

Rank Lead Manager Amount $m No of issues Share %
  • Last updated
  • 18 Oct 2016
1 JPMorgan 14,593.71 79 10.38%
2 Goldman Sachs 11,713.19 63 8.33%
3 Morgan Stanley 9,435.23 48 6.71%
4 Bank of America Merrill Lynch 9,019.27 40 6.41%
5 UBS 8,763.73 42 6.23%