Choosing a Settlement Member in the CLS Era

• CLS' popularity in Asia is expected to increase with the inclusion of the Singapore and Hong Kong dollars in 2003 and 2004, respectively.
• This case study examines how Dah Sing Bank (DSB), as a third-party participant, came to choose HSBC as its CLS settlement member.
• DSB's comparison of potential settlement members was not limited to the traditional criteria such as system requirements and pricing, as these factors were found to be similar among settlement members' third-party participant service proposals; rather, DSB expanded its examination to include the quality of pre- and post-implementation support, the degree of data confidentiality and the timeliness of real-time information access.

Continuous Linked Settlement (CLS) is a new multilateral clearing system for foreign exchange (FX) transactions. It uses the technique of payment-versus-payment to eliminate cross-currency settlement risk (also known as Herstatt risk1) by enabling an irrevocable and simultaneous exchange of a pair of currency payments in an FX transaction settlement between the two parties involved.

Settlement under CLS is entirely centralised at a single entity (i.e. the CLS Bank2) on a gross basis, while funding for these settlements will be done on a multilaterally netted basis. The system began operation in September 2002 with seven of the world's major currencies. These currencies are the Australian dollar, British pound sterling, Canadian dollar, euro, Japanese yen, Swiss franc, and United States dollar. Other actively traded regional currencies such as the Danish krone, Swedish krona, Norwegian krone and Singapore dollar joined in September 2003. The Hong Kong and New Zealand dollars and the Korean won are scheduled to be included in the system in subsequent phases.

As a third-party participant, one must balance the tangible and intangible costs and benefits from joining the CLS system through the services offered by the chosen settlement member. An article entitled "CLS Live: Direct or Third-party Membership?"3 written by Rob Bolton of HSBC in the 2003 edition of this Guide provided a useful checklist to considering the merits of a third-party membership. This set of criteria can also be applied to assess the value proposition from a settlement member to a third-party participant.

CLS Situation in Asia

In general, a third-party participant faces three major questions in CLS: whether to use CLS, when to use CLS, and which settlement member to use. When compared to those in Europe and the US, banks in Asia are in the earlier stages of adopting CLS. Most are considering the first and second question but only a few are touching on the third one. The first and most obvious reason for this is that the early adopters of CLS (i.e. settlement members) are mainly banks in Europe and the US. In other words, most banks in Asia could only join CLS after November 2002 - a time when third-party participants were allowed to join.

On the other hand, most banks in Asia are local or regional banks whose FX trades are mainly with their respective local currencies. For example, for a local bank in Thailand, it is common to find that USD/Thai baht transactions account for over 80% of its FX trade count. Since there are only two Asian currencies among the first seven CLS currencies, local banks in Asia may easily have a perception that CLS is of little relevance to them. As adopting CLS means additional costs to make their treasury settlement system CLS-compliant, Asian banks have tended to adopt a wait-and-see approach.

The popularity of CLS has, however, been picking up in Asia. First, local banks will have an increasingly higher proportion of CLS-eligible trades since increasingly more Asian currencies will be included. In particular, the Singapore dollar joined in September 2003 and the Hong Kong dollar will join in 2004. Second, after the first one or two banks in a country join CLS, their counterparts in the same country will naturally tend to follow out of competitive considerations. Hong Kong is one of the areas in Asia with relatively active CLS participation. In the following section, we will use a case study on Dah Sing Bank to illustrate how a third-party participant chooses its settlement member.

A Case Study

Dah Sing Bank, Limited (DSB), founded in May 1947, is a leading local bank in Hong Kong and is active in personal and commercial banking. DSB's parent company, Dah Sing Financial Holdings Limited, has been listed on the Hong Kong Stock Exchange since 1987, and has gained a reputation as one of Hong Kong's most progressive and innovative financial services groups.

Long before the CLS system was operational among settlement members in September 2002, a number of major financial institutions, including HSBC, approached DSB to present their CLS third-party participant proposals. DSB, which is also in the forefront of adopting best risk management practices among the local banks in Hong Kong, embraced the CLS concept. But in light of the substantial initial investment involved in becoming a settlement member at the outset and DSB's relatively light daily FX settlement volume, in terms of both dollar value and number of transactions in those CLS-eligible currency pairs, DSB decided to participate in the CLS system as a third party to reduce the cross-currency settlement risk through this more cost-effective means.

DSB examined the potential system requirements imposed by the settlement members in accessing the CLS system through their third-party service. The various proposals received by DSB, regarding system requirements were rather similar because all settlement members interact with the CLS system through standardised member application software supplied by IBM.

The standardisation implies no significant cost differentiation in developing the required changes to DSB's existing treasury back-office system software so it can automatically identify CLS-eligible transactions by counterparty, currency, product and timing. The standardisation also allows major system vendors to develop new "turnkey" or system upgrade solutions that could further minimise the risks associated with system changes because the required changes would be professionally developed by reputable software vendors in full compliance with the standardised requirements.

DSB chose the latter approach by upgrading its existing treasury back-office system software to a CLS system-compliant version offered by the software vendor, thereby reducing the system development time required to become CLS compliant. To verify the system readiness, CLS system tests with the chosen settlement member were conducted prior to implementation.

The commitment and thoroughness of the system test support provided by the settlement members, as presented in their respective proposals, were some of the key differentiating factors in the selection process. DSB selected those members that provided a comprehensive testing programme including:

- connectivity to the settlement members' system;

- manual entry test scenarios such as failed trades, unmatched trades, amendments and rescinds;

- system entry test scenarios for straight-through processing;

- free-format test scenarios for irregular transactions; and

- live end-to-end trials via other participants in the CLS system with low-volume and low-value transactions before implementation.

DSB favoured those settlement members whose CLS control and support units were located in the same time zone, and preferably in the same locality. However, this unit's independence from the settlement member's other operations, especially its treasury functions, was essential to ensure that DSB's privacy would be well protected.

The rigid funding period (i.e. 07:00 to 12:00 Central European Time) imposed by the CLS system implies the need for intra-day liquidity for all participants (regardless of their status as a settlement member or third-party participant) because money must be pre-funded early in the day to ensure disbursement later in the same day. DSB preferred to partner with a settlement member that was also a direct member in all CLS-eligible currencies' local real-time gross settlement payment systems. Thus, the settlement member would be in a position to offer a multi-currency intra-day liquidity facility, preferably free of charge, to its CLS third-party participant.

Under such an arrangement, the time-critical funding requirements of the CLS system would become transparent to DSB's treasury function, and it could continue to manage DSB's daily funding and liquidity requirements as usual. The treasury settlement function, on the other hand, would need to obtain real-time information to monitor and manage the CLS-eligible transaction flows. Although the CLS Bank provides real-time online status information through its member application software, it lacks user-friendly report functionality and attributes. DSB selected those settlement members that could provide the CLS-related information in a user-friendly format and on a real-time online basis.

Pricing is, traditionally, a crucial determinant in selecting any service provider. Given DSB's light settlement volume in the current set of seven eligible currencies, DSB did not expect to receive any preferential pricing from the transaction-based pricing model used by the CLS Bank in charging the settlement members. However, if the chosen settlement member had already attained the discounted pricing from the CLS Bank through its own institution's activities, its third-party related activities routed through this settlement member could also enjoy the lower tariff.

DSB found that many settlement members, given the high volume of their settlement activities, were willing to share the privileged pricing they were charged by the CLS Bank with no mark-up to their third-party participants. Therefore, the almost uniform pricing schemes proposed by different settlement members negated the importance of the pricing factor in the selection process.

As third-party participants have no direct relationship with the CLS Bank, if a loss is incurred due to a failing member, the CLS Bank is not in a position to allocate such losses to a third-party participant. However, the CLS Bank will allocate such losses among those members that have settled trades against the failing member on the day of failure. If the CLS Bank is unable to fully recover such losses, the settlement members are additionally subject to an evergreen "general loss" allocation. DSB was mindful of such general loss provisions and preferred those settlement members that did not pass on such general losses to their third-party participant service subscribers unless such a claim could be identified back to a specific third-party transaction.

Conclusion

These were some of the key considerations studied by DSB in choosing its settlement member in CLS. The HSBC proposal scored highly on pre-implementation support, proximity of production support, data confidentiality, liquidity support, and real-time information access factors. Since the system requirements by different settlement members were similar and pricing was homogenous, these two factors played a much less significant role in the decision-making process. DSB has thus chosen to partner with HSBC in joining the CLS era.

2. The CLS Bank is owned by 70 of the world's largest financial groups through the CLS Holdings AG. Each shareholder is required to contribute a paid-up capital of USD5m to become a direct participant of CLS as a settlement member. Together they represent over 80% of the world's foreign exchange business by value. The CLS Bank operates in London and is regulated by the Federal Reserve Bank of New York. More detailed information is available from the CLS web site at www.cls-group.com.

3. The article is on pages 95 to 100 of "HSBC's Guide to Cash and Treasury Management in Asia Pacific 2003".

Authors: Y. S. Wong, General Manager, Risk Management & Control Department, Dah Sing Bank, Hong Kong, and David Yau, Vice President, Sales, Global Payments and Cash Management, Asia Pacific, HSBC, Hong Kong