Managing risk and maintaining liquidity is important for any institution, but more so for an organisation that requires swift and efficient access to the FX market.
The FX market’s position is unique in underpinning the stability of businesses and international trade. On average, $5.3 trillion is exchanged every day, according to the Bank for International Settlements (BIS).
So the uninterrupted operation of the FX market is of a critical nature that stretches far beyond the trading floors of the largest international banks.
In 2010, statistics from BIS showed that 85% of market growth from 2007-2010 came primarily from non-banking institutions (NBIs), which includes international corporations.
Fast forward a further three years to 2013, and the BIS survey showed that non-financial customers, mainly corporations, collectively traded an average of $477bn every single day. That is greater than the annual GDP of countries such as Austria, Denmark, Egypt, Portugal and Thailand.
With such high values of currency being traded and exchanged every day, any failed or delayed payments can have a significant impact on daily cash flow and create unexpected liquidity demands in one or more currencies. Managing cash flow, especially in multiple currencies, is essential to the smooth running of any global treasury function. Cash-flow interruptions, or a sharp, unexpected move in exchange rates, are a cause for concern for a corporate treasurer.
According to UBS, when the Swiss franc moved 40% in less than a few hours on 15 January this year, it made life extremely difficult for Swiss financial firms and exporters, who became a lot less competitive as a result.
The same applied to US corporations after the strengthening of the US dollar in the first quarter of 2015, which impacted the earnings of numerous publicly listed corporations.
The primary reasons for trading currencies are to fund obligations arising from business transactions, pay staff and suppliers, meet credit and banking obligations, pay tax in local jurisdictions and facilitate hedging of existing financial positions to manage risk. Corporations with sophisticated treasury functions will typically have well-developed hedging programmes to counter price risk (ie movement of the exchange rate).
But even the most sophisticated corporations have not considered another crucial risk inherent in the FX market: the risk that settlement will be disrupted. In the extreme, the corporation might pay its part of the trade and not receive the counter value. If the counterparty fails, the corporation might lose the entire amount it has paid. This is called settlement risk.
Failure to protect an institution from settlement risk could lead to significant shortfalls in capital ratios and cash flow, with knock-on effects on profit and loss, risk management and the possibility of a contagion effect on other institutions, industries and entire national economies.
This is where CLS comes into play. Recognising the need to address this risk, the FX industry’s largest participants and central banks spearheaded an effort that ultimately created CLS, introducing a mechanism for safe, secure and final settlement of FX transactions.
The prospect of settlement risk and interruptions to cash flow remains very real for many corporations
With economic and business sentiment improving around the world and globalisation contributing to a rise in international cross-border trade, settlement risk remains front of mind for many international corporations.
Aside from receiving certainty that trades are settled and monies are received safely, a high degree of accuracy in the management of cash flow is critical to navigating the external environment, particularly at times of market volatility.
Many corporations already have integrated financial systems and are able to aggregate financial obligations to provide accurate cash forecasts. But, in many cases, funding arrangements have to be organised well in advance and the full value often has to be put aside.
An important benefit for corporations mitigating settlement risk via CLS is the visibility of matching and settlement of trades. With trades typically matched within 20 minutes in CLS and real-time reporting of trade status, corporations have an immediate picture of how much funding is required to meet their obligations. Corporations acting as third parties in CLS often see an increase in their available pool of counterparties, resulting in access to more competitive pricing, which lowers costs.
In addition, while settlement occurs on a gross, individual payment-versus-payment basis, the funding required by CLS’s members is calculated on a multilateral netted basis.
As a result, some members have reported that this process results in a reduction of funding requirements by over 96% – meaning the cash required to settle all trades is reduced significantly. There are, in turn, significant netting benefits to be gained by corporations. If trading is conducted away from CLS, much, if not all, of this cash could potentially be inaccessible.
Accurate cash forecasting, minimising the number of payments and reducing trading errors and manual processing ensures participants are able to improve their cash management and trade reconciliation cycle significantly.
In recent years, the FX market has evolved almost beyond recognition as a result of new technology, people and innovation. A core catalyst has been the transformative increase in participation from a diverse range of corporations and others, which has driven trading levels to record highs.
But the prospect of settlement risk and interruptions to cash flow remains very real for many corporations, and any adverse movements can expose them, their counterparties and their stakeholders to potential systematic failure.
With the FX market more diverse and interconnected than ever before, and institutions under regulatory pressure to meet capital and risk management requirements, access to cash in the midst of market stress can play a defining role in the success or failure of a business.
The 2008 crisis showed how the fall of one institution could have an effect that stretches far beyond its walls. Given the critical nature of currency markets to international commerce and the financial system as a whole, the question must be asked: Is it worth the risk?
Jonathan Bowler is head of relationship management at CLS