The risk of failed trades in the vast global foreign-exchange market has never been higher, according to the chief executive of CLS, the central bank-backed settlement service, which admits that it has struggled to keep pace with rapid growth in the industry.
CLS was set up in 2002 under the auspices of the US Federal Reserve to act as a middleman in trades, authenticating and matching instructions to ensure that correct payments are made. The system came through a big test in the 2008-09 financial crisis and again earlier this year with the Covid crisis, helping to safeguard the smooth functioning of the $6.6tn-a-day currencies market.
However, in a study prepared by CLS and published on Friday by the Global FX Committee, the standard-setting body for the currency market, the company found that it now handles just one-third of the deals that are eligible for settlement. On top of that, some $1.25tn of daily transactions are now outside its scope thanks to particularly strong growth in renminbi and rouble trading. The company is set up to deal in 18 currencies, most of which are from advanced economies.
“Given the way in which FX trading has evolved, we have to think of additional ways to solve the problem of systemic risk,” said Marc Bayle de Jessé, chief executive of CLS, who joined the New York-based company last year after more than 20 years at the European Central Bank.
He noted that CLS was discussing with regulators and central banks ways to include emerging market currencies when they are traded against the dollar or the euro. He added that the risk of disruption appears greater than “the original Herstatt risk” — a reference to the infamous 1974 payment failure by a German bank that triggered market seizures around the world.
The warning echoes remarks from the Bank for International Settlements, which observed in December that the share of deals backed by CLS had fallen, leaving trillions of dollars of transactions vulnerable to default risk. Last month the GFXC expressed concerns too, saying currency markets faced “potentially very significant” risks due to the amounts involved.
Banks have long complained about the costs of using CLS, an acronym that stands for Continuous Linked Settlement. In 2008, the German state-owned development bank KfW was dubbed the “dumbest” bank in Germany by local media after suffering €300m of losses on a currency deal with Lehman Brothers that was not sent to CLS for settlement.
But many participants in the market still opt not to use the service, trusting that their counterparties will pay up as they promise. That sets the FX industry apart from other financial markets, which make much greater use of central venues to manage default risk, such as exchanges or clearing houses.
Mr Bayle de Jessé admitted that the process of introducing new currencies into the system was cumbersome, and could take a long time. CLS is in discussions with the central bank of Chile about potentially adding the peso. The last addition was the Hungarian forint in 2015.
“Bringing in more currencies under the current framework is complex and confronts various challenges,” he said. “We are looking at options to reduce settlement risk . . . at least for [emerging market currencies traded against the dollar or the euro].”
CLS has faced growing competition in recent years, mainly from start-up Cobalt, which is backed by Citigroup, Standard Chartered and IHS Markit.