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FX - After the trade is made The future of the CLS relationship Olaf Ransome

This article was originally published in FX Week on 20th September 2010

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Beckenhofstrasse 1, 8006 Zurich, Switzerland T +41 44 887 63 08 olaf.ransome@3cadvisory.com www.3cadvisory.com


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Regulation: the two edged sword of opportunity and threat The FX industry today is largely unregulated; yet it is huge and functions extremely well. Markets are liquid, pricing is pretty transparent and the settlement end of things works. It has been other areas of banking that have malfunctioned recently; indeed, during the disruption around the Lehman collapse in September 2008, the FX markets and CLS in particular weathered the storm without incident. But, without doubt, regulation and change are on the way. There is widespread expectation that the Dodds-Frank legislation will lead to options having to be cleared. Given all that transparency, the margins are likely to stay the same. so an important question for the industry is what will be the impact on costs; what will need to change on the infrastructure front, what will it cost to build and how much to operate. Today’s cost of FX infrastructure. For any bank or broker active in the FX markets, there are three big blocks of costs: Pipes, Clients and Liquidity. Pipes: this is what it costs to configure and run the back-office. In FX, the major piece of external infrastructure is CLS. Use of CLS for cash trades is certainly the norm in the interbank markets. For the direct participants, the Settlement Members, there are two connections: one to the core cash system and another for options and NDF’s. Going forward there will only be the one. Some banks will have single platform for FX backoffice, some will have separate ones for cash and OTC derivatives. These too need to be maintained and will need to be adapted to deal with a new world in which options are cleared. Clients: there are lots of clients that don’t want to use CLS. Some of them prefer front-end netting, via services such as NetLink, or bi-lateral netting. Some, sadly do not do either. Liquidity: if there was only CLS, this would be a non-issue. Sadly, as an industry it is something we have to deal with and it is not cheap. Entropy kills, or in simpler terms, having to deal with Heinz 57 varieties drives up the costs of doing business on a series of uneven playing fields. How would we like to deal with the new world of options clearing? One’s perspective on this will depend on where you start from in your thinking. If you are a CLS Settlement Member, then you might start form the liquidity point of view. Given the vast number and value of trades going through CLS and the imperative of settling everyday, this is a great starting point. If you are running FX Operations, you want to protect liquidity; now, at the end of an options contract is a delivery, so it seems a very reasonable starting point to say that any new process for FX options should strive to have CLS at the back end in order to help manage that precious commodity, liquidity. As far as the CCP and clearing element is concerned, this is not a CLS core competency and there are existing processes for this. CLS already understands how to partner with others to support industry efforts; the cooperation with DTCC for settlement of cash flows from CDS is a success. A partnership, or indeed several, should enable a sound process for options to be developed. An alternative view of this would be the perspective of a derivatives specialist; if all NDF’s and Options are processed on a different platform, then your view may well be that a process similar to other derivatives is desirable. Considering all of these things, a pragmatic stance emerges; to help manage liquidity, it is important that CLS is part of the settlement process. There is already hard evidence that CLS can partner well with other industry utilities and the 60 largest institutions already have pipes to CLS. Taking those things together, the low cost route to options clearing would seem to be one that is CLS centric. Persuasion or compunction? Today, the use of CLS is something that is the norm. It is however not compulsory. In fact, there is no regulatory requirement to use it. it came to pass through strong moral suasion. In the earlier days one COO remarked to me that CLS was “just a tax on doing business”. Over the years, whilst that view has no doubt softened as the realisation has dawned that it offers cheaper counterpart insurance than a CDS, it is still the case that the industry has to bear the costs of the CLS world and the non-CLS world. That makes FX operations expensive. Sadly, in an unregulated market, some players avoid using CLS. One large Austrian bank I spoke to recently nearly refused to use CLS and wanted to settle gross, because they felt our client’s credit was good and they did not want to pay the CLS ticket fee. They had no concept of the impact on their liquidity of having some trades in CLS and others out. And, the cost of settling gross is certainly not significantly cheaper. In this case, the only legitimate conclusion is:

FX Week Article - Sept 2010

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“Stupid bank, short the shares and call their regulator”. Then we have the emerging markets banks; happy to do USD / TRL, insist on trading USD / EUR too and then are not CLS members. The right incentives: In looking at the future for FX infrastructure, understanding the present highlights a salutary lesson. Today, there is no incentive to take part in or penalty for not using CLS. At times, there have been suggestions that CLS would lead to there being two prices in the market, Well, eight years on, this has not happened. At an industry event some years ago, in a forum discussion about how to increase CLS usage, a senior staffer from the ECB asked why the CLS users did not get together and simply agree not to offer a price to non-users. An interesting suggestion, however as happy as such an effort might make the ECB, we did need to point out that this would bring about some unwanted attention from Euro bureaucrats in the anti-trust division. There is no regulatory capital benefit or penalty either. Any new regulation needs to consider this status quo in the largest FX market, cash trading. In the debate around the treatment of options, earliest signals are that there will be regulatory charges for those not using a clearing solution. This would be very welcome, especially if coupled with a deadline. The financial services industry works best with clear rules and deadlines. Operating our infrastructure is an immensely expensive business and there is no choice but to work together in order to settle transactions. When there is incomplete regulation and no appropriate incentives, or disincentives, then inefficiencies creep into the system. Invariably, the cost of these inefficiencies are transferred to those who follow the recommendations. So, as our industry experts and the regulators consider the future, there are some important considerations: Disincentives: At last. Great idea. However, two important things need to be built into the design. Firstly, if there are disincentives, do they create a level playing field. Will the regulators of those emerging markets banks also have the same rules? Secondly, do not stop at options. Impose the same approach for all FX products; use PVP where it is available, use clearing where there is an extended period before settlement. With all the FX playing fields levelled, the costs will come down and the level of control will increase. Pipes & Liquidity: the solution to support clearing must be CLS centric. Ideally, CLS is at the back end so that any settlement is netted with all other activity. Using the existing CLS pipes is likely to minimise the cost to build and operate, as well as time to market. Currency Coverage: We need to add to CLS the means to deal with more than the 17 currencies it supports today. That work is in progress; any help that can be given to accelerate it would be welcome. Potentially, some less liquid currencies could be settled in a different way than the core 17. To paraphrase something once said about advertising: “regulation is not necessarily a good or a bad thing, it depends on the use to which it is put”. A stand alone FX option, G20 country centric solution regulation would simply add costs to the industry for limited gain and would be an opportunity squandered.

FX Week Article - Sept 2010

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