Continuous Linked Settlement (CLS): Then and Now (Including a snapshot of the BIS Triennial Central Bank Survey 2013)

Continuous Linked Settlement (CLS): Then and Now (Including a snapshot of the BIS Triennial Central Bank Survey 2013) Seema Ganapathy* CLS - Growth story: Owned by 77 of the world's leading financial institutions, CLS plays a fundamental role in the The currency markets are the largest and most FX market - it operates the largest multicurrency liquid markets in the world with an estimated cash settlement system to mitigate settlement $5.3 trillion changing hands each day (BIS risk for the FX transactions of its Members and Triennial survey 2013). Steering this large, mostly their customers. The CLS system facilitates real volatile market that straddles most of the time settlement of the payments associated with countries across the globe into safer waters is a currency trades among the world's major trading fairly unknown entity called the CLS Bank. institutions in the foreign exchange markets on a Continuous Linked Settlement (CLS) is one of payment versus payment mechanism. the eight financial market utilities in the world - Instructions from counterparties to an FX trade entities that engage in risk management activities are authenticated, matched and settled on an such as clearing and settlement to have been agreed date in 17 currencies. designated as systematically important by the US Financial Stability Oversight Council (FSOC). Funds are settled irrevocably in a 5 hour window during which trade funding, settlement and CLS was launched in 2002 with 39 direct payment are executed among participants. The participants and 7 currencies to eliminate Central institution, CLS Bank, has links with the settlement risk, one of the biggest dangers in the real time gross settlement RTGS payment systems FX markets. Today, it has 64 settlement members of 17 currencies eligible to be settled over CLS interfacing directly with the CLS Network and and performs the functions of a clearing house over 11,000 third party users which are settlement. In order for this to happen, RTGS institutions that clear and settle payments via the timings of some currencies have been extended system indirectly through correspondent to ensure they overlap across time zones. banking services provided by a settlement member. Ms. Seema Ganapathy is Manager, Forex Settlement Department The Clearing Corporation of India Limited CCIL Monthly Newsletter December 2014 7

Central European Time (CET/CEST) In/Out Swaps Settlement Funding: Pay-ins & pay-outs 00:00 Initial Pay-in schedule 07:00 Start of funding and settlement 10:00 End of funding (Asia/Pacific) 12:00 End of funding (Other currencies) 06:30 Revised Pay-in schedule 09:00 End of Settlement (target) CLS Summary Commenced Live operations 9 th Sept 2002 No of direct participants No of indirect participants (third & fourth parties) Average daily volume Active currencies (17) New currencies in the pipeline 62 settlement members 2 User Members 11000+ USD 5.94 trillion (Sept 2014 figures) NZD, JPY, AUD, HKD, SGD, KRW, DKK, SEK, CHF, ILS, ZAR, MXN, EUR, GBP, NOK, USD & CAD Brazilian real, Chilean peso, Chinese Yuan, Russian ruble and Thai baht December 2014 CCIL Monthly Newsletter CLS -Epitome of efficiency in times of financial crisis The biggest testament to the success of CLS is seen in its performance during the Lehman crisis. Post the Lehman Brothers collapse in 2008, when many markets were run aground, CLS was able to ensure that forex markets continued to function smoothly. CLS was created specifically to prevent cross-currency settlement risk (also known as Herstatt risk, after the German bank whose failure in June 1974 led to massive FX trading losses at its counterparties). Because of the stability and transparency CLS provided, Lehman's failure did not severely disrupt the market, as was the case with Herstatt Bank. CLS had done its job. The European Central Bank, in a March 2009 report analyzing the operational lessons from Lehman's demise, found that, at the end of the day, CLS proved that it effectively offsets the problems it was designed for, i.e. to prevent a systemic crash by removing principal risk (the so-called Herstatt risk). The report further concluded: The Lehman downfall proved that CLS is an effective measure to mitigate settlement risk. 8

CLS Key Considerations: 1. Eliminating settlement risk CLS addresses settlement risk through a payment versus payment (PVP) process. Each of the two parties to an FX trade pays out one currency and receives another simultaneously, thus avoiding the possibility that an institution pays out funds without receiving reciprocal funds due. In effect, CLS eliminates settlement risk in FX, the world's single largest financial market. 2. Greater operational efficiency In addition to removing settlement risk, CLS offers a number of operational and liquidity benefits, leading to significant cost savings. For example, CLS members base their daily funding requirements on a multilateral net position, rather than gross transaction-by-transaction funding, which reduce necessary daily funding by 95%. Accordingly, CLS members have to fund less than US$50 bn a day for every US$1 trillion of value settled. CLS members also enjoy the benefits of STP, lowered payment volumes and fewer failed settlements. 3. Offer third-party services Financial institutions that choose to become settlement members of CLS have the opportunity, in turn, to offer CLS settlement services to other institutions on a third-party basis. 4 Streamline risk management As well as the clear advantages of the elimination of settlement risk, CLS provides operational oversight and controls throughout the transaction life cycle, bringing consistency and efficiency to the risk management process. 5. Enhances treasury functions CLS's same-day funding cycle greatly reduces the cash outlays required to complete settlements. In addition, multilateral netting reduces the number and amount of payments that must be made. As settlement is virtually guaranteed, this gives treasury groups earlier notification and confidence with their intra-day credit lines. The end-of-day reconciliation process for the bank's trades also becomes more efficient as they are no longer reliant on an individual payment to settle a single trade. 6. Trading with more counterparties The CLS process encourages trading with additional counterparties and may lead banks to consider counterparties that they have not traded with previously. 7. Increased FX trading Since FX trading is more secure, efficient and cost-effective in CLS, banks might embrace FX trading for cross-border funds movement on a more frequent basis. 8. Utilization of best practice Through the use of CLS, participants are involved with the industry's best practices for FX settlement, supporting compliance with their internal audit requirements. 9. Optimize central bank relationships Central banks around the world are staunch advocates for participation in CLS. Financial CCIL Monthly Newsletter December 2014 9

institutions that become settlement members help support common global goals that contribute to financial stability. CLS: Issues and Challenges: 1. The FX market has grown tremendously over the past 11 years. When CLS started, it processed an average of 5,700 payment instructions each day. At the height of the 2008 crisis, it processed 1.5m instructions on a single day and settled over 10 trillion U.S. dollars. The utility should be capable enough to process increased trade volumes effectively and efficiently over the years to come. currencies, legislation can take years rather than months to be passed. Perhaps, if they are not added soon, those currencies will continue to grow outside CLS. Exchange greats Global foreign-exchange market* %of average daily turnover US Dollar Euro Japanese yen British pound Australian dollar Swiss franc 0 10 20 30 40 87.0 84.9 December 2014 CCIL Monthly Newsletter 2. The greater problem facing CLS is to accelerate the addition of new currencies it settles. The most recent were the Mexican peso and the Israeli shekel, back in 2008. Non-CLS currencies represent only 6.3% of daily volume in the triennial BIS survey but they include some of fast-rising importance, such as the Chinese Yuan and the Russian Rouble. The Yuan vaulted into the top ten most-traded currencies in the latest survey (see chart), although further growth in international trading of the currency could rely, to some extent, on its joining CLS. The Brazilian Real, Chilean Peso, Thai Baht and Polish Zloty are also high on the list of priorities. Addition of a new currency is not an easy proposition, it requires the full support of officials in the prospective country including regulators and the central bank. However committed CLS is to adding more Canadian dollar Mexican peso Chinese yuan Nwe Zealand dollar Apr 2010 Apr 2013 *Adjusted for local and cross-border inter-dealer double-counting; percentages sum to 200% as two currencies are involved in each transaction Source: BIS Not covered by CLS 3. Another issue is the CLS transaction processing cost. Transaction fees are based on a value volume cost model and fees that members pay can vary from one bank to the next. With an increase in trading volumes more trades are settled through the CLS system; to keep up with the pace CLS has had to invest in technology and risk management to service these trades. The cost of increased regulatory compliance requirements has also been cited as one of the reasons why the baseline fees as paid by banks have hiked over the years. 10

In fact in 2013, CLS Group (CLS), announced the successful completion of an equity capital raise for a net amount of 160 million, which enabled it to comply with increased regulatory capital requirements, meet operational needs and establish an appropriate capital structure to benefit from future growth in the global FX market. 4. Concerns also have been raised on the third party model- that some third parties were so large that the banks (Settlement members) may not have the capability and risk mechanism to handle such exposures. While CLS believes that systematic risk is reduced if large institutions settle FX transactions as direct members, however not all third parties can get to be direct members under the CLS Bank rule criteria. The flip side is that while third - party services have increased manifold post the Lehman crisis, a majority of these are made up of corporate, hedge funds, pension funds etc (who find it convenient to settle net through CLS), all such third - parties carry the element of settlement exposures on their agents. No rules have been made to bring such entities direct under the CLS ambit. 5. One of the consequences of the Global Financial Crisis has been a sharply increased focus on regulating OTC derivative markets; one of the key areas of increased regulatory focus being counterparty credit risk mitigation by moving towards centralized counterparty clearing for OTC derivatives. A derivatives contract is cleared" when the performance of the buyer and the seller is effectively guaranteed by a special purpose financial utility known as a central clearing. Foreign exchange swaps and forwards are exempt from central clearing framework under the Dodd Frank Act for the reason that the main attendant risk- settlement risk is addressed through the CLS mechanism. However the CLS Bank does not guarantee the settlement of such instruments. The component of market risk still exists for all such instruments that are settled through CLS, which in the case of forwards can be high. In India, this risk is recognized and clearing of forex forward has been mandated by the Central bank. CCIL, based on robust risk management systems has been able to effectively clear forex trades for the Indian market through its guaranteed USD INR & Forex Forward settlement products. Mandatory central clearing of FX products raises questions about how CLS will mitigate settlement risk for cleared products such as options, and whether clearing houses can become direct members of CLS. Having very effectively concentrated its efforts on the reduction of settlement risk in years gone by, CLS has never had to concern itself very much with counterparty credit risk, which is mitigated in other asset classes by central counterparties (CCPs). But as dealers and CCPs now grapple with the challenge of clearing over-the-counter - FX options - having so far cleared only non- CCIL Monthly Newsletter December 2014 11

December 2014 CCIL Monthly Newsletter deliverable forwards - CLS will need to determine how settlement risk will continue to be mitigated when a CCP is added to the market ecosystem. CLS's Strategy-Providing Risk Mitigation services to the Fx markets: 1. The nature and dynamics of the FX market have been in a state of constant flux over the last decade and, consequently, CLS has seen significant change in terms of what the market requires of it. In 2007, CLS began providing settlement of payments for the DTCC Deriv/SERV's Trade Information Warehouse, a central post-trade processing service for over-the-counter credit derivative transactions. 2. In 2009, with the rise of algorithmic trading, CLS began its trade aggregation service - named CLS Aggregation - to address the demand driven capacity issues that were responsible for bottlenecks in some financial institutions' back offices. Aggregation helps to compress the number of tickets that are settled and reduce operational risk and is a service that entities like hedge funds cherish. 3. In 2013, the CLS Group launched new same day settlement service for US dollar and Canadian dollar transactions. The Same- Day Settlement solution was a result of client demand to remove FX settlement risk in the liquid currency pair. The solution allows members to settle and take delivery of transaction on the same day. This first sameday session will provide a model for future expansion of settling same-day trades in other parts of the world. 4. In continuation with its strategy to support expanding markets, CLS has a clear goal of expanding its currency coverage and is effectively working towards expanding the currencies it settles. CLS: The India Story: On the lines of the guaranteed settlement model of USD/INR inter-bank-trades (operating at netting efficiency of over 95%) the Indian financial markets sought benefits of reduced credit, market, operational and liquidity risk and improved operational efficiency for trades in other currency pairs as well. CCIL selected the Continuous Linked Settlement (CLS) system for cross-currency transactions. However, rather than directing individual banks' trade to CLS Bank, CCIL sought to simplify access for Indian banks. CCIL acts as third party aggregator and settles the transactions of its member banks through a designated settlement member Royal Bank of Scotland (RBS). CCIL facilitates the settlement of cross currency deals for banks in India in 14 CLS eligible currencies through the CLS Bank since April 2005. CCIL's prime objective was to improve transaction settlement efficiency, mitigate risks, insulate the Indian financial system from operations-related shocks, and undertake other activities that help to broaden and deepen the money, debt and FX markets in India. Through this arrangement, CCIL has been able to pass on concrete benefits of the CLS product viz. 12

operational efficiencies, reduced liquidity requirement and other benefits to its member banks. India is the only country in the world where settlement of cross currency transactions of major market participants is done through a unique fourth party model. Additional benefits for banks in India: Banks in India (currently 34) availing the services of CCIL do so as fourth parties. CCIL acts as an aggregator in the process and is termed as a third party and hence is in a position to operationally simplify the process for banks and offer CLS services. The banks that have joined CCIL as members have of course availed the risk mitigation benefits that CLS offers. In addition they benefited by:- currency wise net positions and obligations, and of payments made and received. 3. The service also offers its members the facility to pay and receive currency obligations within the operating timelines of the respective currencies, subject to availability of limits. 4. Enhanced credit lines: CCIL accepts collateral in local currency, and by virtue of its role as a Central Counter Party, is able to offer banks the ability to leverage on their unutilized collateral posted towards margins for its settlement services. By using local collateral banks can get the benefit of early payouts so that they can deploy the funds in the local markets. Under the umbrella of CCIL, the CLS solution has gained immense credibility with the domestic participants. 1. Ease of operations - CCIL has also been able to leverage its infrastructure and capabilities as a CCP including making use of the connectivity and communication already established with the banks and leverage unutilized balances of their margin pool placed with the CCP for meeting the margin requirements of segments to collateralized payouts in some currencies etc. 2. Lower costs both because of fewer system changes are required at the member's end to access the solution as it is web based and because CCIL's aggregation model brings them volume discounts. A real-time web based tool enables members to track online status of deals submitted, of CCIL CLS Fact File: Live Operations commenced value April 06, 2005. Settlement Agent - Royal Bank of Scotland, London. Aggregator of trades reported by Member banks in India & Settlement on Payment versus Payment. Currently offers settlement in 14 CLS eligible currencies. As on date 34 members as fourth parties in the CCIL CLS segment out of which 32 are live in production. Average number of trades settled per day - 2000+. Average gross volume of USD 3 billion per day. CCIL Monthly Newsletter December 2014 13

CLS: Large-scale Benefits CLS is today recognized as a powerful tool for reducing operational effort and risks on FX trades - as well as costs - while also lowering settlement risk. Besides reducing risks, the benefits from using CLS include higher visibility of the settlement process (via real-time reporting), matching of trades, netting of payments and process automation. Based on the current credit climate situation, the growth of CLS users will continue in the coming years. CLS Settlement Process Flow Chart Party A Nostro Party A (4th party) Trade Party B CCIL's Nostro Net payment message CCIL (3rd party) CCIL Settlement Agent RBS Party B's Settlement Agent (SA) Net payment message Trade Instruction Match CLS Bank Net payment message RBS Nostro Party B's SA Nostro payments CCIL CLS Top 3 currency pairs (Figures in USD bn) 450 December 2014 CCIL Monthly Newsletter U S D B i l l i o n s 400 350 300 250 200 150 100 50 250 133 387 386 111 38 34 130 48 200 140 EUR/USD USD/GBP JPY/USD 100 0 2010-11 2011-12 2012-13 2013-14 14

CCIL CLS Volumes (Figures in USD bn) 800 700,000 G R O S S V O L U M E 700 600 500 400 300 200 100 441,933 394,415 647 470 61 77 594,816 570,308 724 630 55 55 600,000 500,000 400,000 300,000 200,000 100,000 T R A D E S S E L E C T E D 0 2010-11 2011-12 2012-13 2013-14 0 Gross Volume Net Volume Trades Settled References: CLS Bank website BIS Website Fx week Risk.net The Economist CCIL Monthly Newsletter December 2014 15

ANNEXURE BIS Triennial Central Bank Survey Results 2013 Foreign exchange turnover in April 2013: global results The BIS Triennial Central Bank Survey is the most comprehensive source of information on the size and structure of global foreign exchange (FX) and OTC derivatives markets. Foreign exchange market activity has been surveyed every three years since 1989, and OTC interest rate derivatives market activity since 1995. The Triennial Survey is coordinated by the BIS under the auspices of the Markets Committee (for the foreign exchange part) and the Committee on the Global Financial System (for the interest rate derivatives part). The latest survey of turnover took place in April 2013. Central banks and other authorities in 53 jurisdictions participated in the 2013 survey. They collected data from about 1,300 banks and other dealers in their jurisdictions and reported national aggregates to the BIS, which then calculated global aggregates. Highlights of the 2013 survey: Global Market Turnover Trading in foreign exchange markets averaged US$ 5.3 trillion per day in April 2013. This is up from US$ 4 trillion in April 2010. Spot market trading increased by 38% to $ 2 trillion per day in April 2013.This contributed roughly a 40% rise in global Fx market activity between 2010 & 2013. Fx swaps continued to be the most actively traded instrument in 2013 although at 27% the rise in trading did not match the velocity with the overall market. Fx swaps daily volume of $2.2 trillion accounted for 42% of all Fx related transactions. GLOBAL FOREIGN EXCHANGE MARKET TURNOVER (Daily averages in April in US$ billion) Instrument 2013 2010 % difference December 2014 CCIL Monthly Newsletter Foreign exchange instruments 5,345 3,971 35 Spot transactions 2,046 1,488 38 Outright forwards 680 475 43 FX swaps 2,228 1,759 27 Currency swaps 54 43 26 Options and other products 337 207 63 Turnover at April 2013 FX rates* 5,345 3,969 35 * Non-US dollar legs of foreign currency transactions were converted into original currency amounts at average exchange rates for April of each survey year and then reconverted 16

Foreign exchange market turnover by instrument 1 Net-net basis, daily averages in April 2001-2013 USD bn 5,000 1% 2010 5% 1% 2013 6% 4,000 3,000 37% 38% 2,000 44% 42% 1,000 12% 13% 0 01 04 07 10 13 Spot Outright forwards FX swaps Currency Swaps Options & Other 1 Adjusted for local and cross-border inter-dealer double-counting, ie "net-net" basis. Turnover by Currencies The US dollar remained the dominant vehicle currency; it was on one side of 87 percent of all trades in April 2013. The euro was the second most traded currency, but its share fell to 33 percent in April 2013 from 39 percent in April 2010. The turnover of the Japanese yen increased significantly between the 2010 and 2013 surveys. So too did that of several emerging market currencies, and the Mexican peso and Chinese yuan entered the list of the top 10 most traded currencies. CURRENCY DISTRIBUTION OF FX TURNOVER -- TOP 10 CURRENCIES (Percentage share of average daily turnover in April)* No. Currency 2013 2010 2010 Rank 1 US Dollar 87 84.9 1 2 Euro 33.4 39.1 2 3 Japanese yen 23 19 3 4 Pound sterling 11.8 12.9 4 5 Australian dollar 8.6 7.6 5 6 Swiss franc 5.2 6.3 6 7 Canadian dollar 4.6 5.3 7 8 Mexican peso** 2.5 1.3 14 9 Chinese yuan** 2.2 0.9 17 10 New Zealand dollar** 2.0 1.6 10 CCIL Monthly Newsletter December 2014 *Because two currencies are involved in each transaction, the sum of percentage share of individual currencies totals 200 percent. ** Turnover for years prior to 2013 may be underestimated owing to incomplete reporting of offshore trading in previous surveys. 17

Turnover by Currency Pair The USD/EUR currency pair retained its dominant position amongst the most actively trades currency pair. Among the major currencies, trading in the Japanese yen jumped the most, Turnover in the USD/JPY pair rose by about 70 percent in this period.. Trading in the most actively traded euro exchange rate crosses, such as EUR/JPY, EUR/GBP and EUR/CHF, expanded less than that in their USD counterparts Among the most actively traded advanced economy currencies, the Australian and New Zealand dollars continued increasing their share in global FX trading. By contrast, sterling, the Canadian dollar, the Swedish krona and, most notably, the Swiss franc lost ground in global FX trading in relative terms TURNOVER BY CURRENCY PAIR (Daily averages in April in US$ billion and percentages, excluding estimated gaps in reporting) 2013 2010 Currency pair Amount % share Amount % share USD/EUR 1289 24.10 1098 27.7 USD/JPY 978 18.30 567 14.3 USD/GBP 472 8.8 360 9.1 USD/AUD 364 6.8 248 6.3 USD/CAD 200 3.7 182 4.6 USD/CHF 184 3.4 166 4.2 USD/MXN 128 2.4 Na Na USD/CNY 113 2.1 31 0.8 USD/NZD 82 1.5 Na Na USD/RUB 79 1.5 Na Na USD/HKD 69 1.3 85 2.1 December 2014 CCIL Monthly Newsletter USD/SGD 65 1.2 Na Na USD/TRY 63 1.2 Na Na USD/KRW 60 1.1 58 1.5 USD/SEK 55 1.0 45 1.1 USD/ZAR 51 1 24 0.6 USD/INR 50 0.9 36 0.9 EUR/JPY 147 2.8 111 2.8 EUR/GBP 102 1.9 109 2.7 EUR/CHF 71 1.3 71 1.8 JPY/AUD 45 0.8 24 0.6 18

Turnover by Counterparty The growth of foreign exchange trading was driven by financial institutions other than reporting dealers. The 2013 survey collected a finer sectorial breakdown of these other institutions for the first time. Smaller banks (not participating in the survey as reporting dealers) accounted for 24 percent of turnover, institutional investors such as pension funds and insurance companies 11 percent, and hedge funds and proprietary trading firms another 11 percent. Trading with non-financial customers, mainly corporations, contracted between the 2010 and 2013 surveys, reducing their share of global turnover to only 9 percent. Geographical distribution of turnover Foreign exchange market activity has become ever more concentrated in a handful of global financial centers. The vast majority of global FX trading in 2013 has occurred via the intermediation of dealers' sales desks in five jurisdictions: the United Kingdom (41 percent), the United States (19 percent), Singapore (5.7 percent), Japan (5.6 percent) and Hong Kong SAR (4.1 percent). FOREIGN EXCHANGE TURNOVER BY COUNTERPARTY (Daily averages in April in US$ billion and percentages) 2013 2010 Counterparty Amount % share Amount % share Reporting dealers 2070 38.7 1544 38.9 Other fin. institutions 2809 52.6 1896 47.7 Non fin. customers 465 8.7 532 13.4 TURNOVER BY LOCATION - TOP 5 COUNTRIES* (Daily averages in April in US$ billion and as percentages) 2013 2010 Country Amount % share Amount % share 1. United Kingdom 2,726 40.9 1854 36.8 2. United States 1263 18.9 904 17.9 3. Singapore 383 5.7 266 5.3 4. Japan 374 5.6 312 6.2 5. Hong Kong 275 4.1 238 4.7 CCIL Monthly Newsletter December 2014 19

Pct Daily Vol BIS Trienniel FX Survey-Pct Daily vol/dealing Location 2013 45.0 40.0 35.0 30.0 25.0 20.0 15.0 10.0 5.0 0.0 United Kingdom United States Singapore Japan Hong Kong SAR Switzerland France Australia Netherlands Germany CCIL Monthly Newsletter December 2014 20