An international consortium of banks has taken a giant step toward completing a system for mitigating risks in foreign exchange settlements.
CLS Services Ltd., a London-based group that has the backing of the influential committee of investment and commercial banks known as the Group of 20, has tapped IBM Global Services to develop a real-time clearing and settlement system for interbank foreign exchange trades.
The contract, valued at about $100 million, calls for IBM to develop the hardware and software for CLS Bank, a proposed exchange-settlement institution that would be based in New York.
Separately, CLS announced an agreement with Swift-the Society for Worldwide Interbank Financial Telecommunication-to handle the networking aspects of CLS Bank. Terms of that deal were not disclosed.
CLS Services said 18 banks have signed letters of intent to use its multilateral netting facilities, which would bring the number committed to 31. The newest include units of BankAmerica Corp., Bankers Trust New York Corp., Citicorp, and J.P. Morgan & Co.
The announcements represent "significant steps in realizing the strategic plan behind the formation of CLS Services to eliminate global banking exposures to FX clearing and settlement," said Stephen Thieke, managing director of J.P. Morgan and chairman of CLS Services.
The CLS group, owned by 40 of the world's largest banks, was formed in 1996 to address the increasingly worrisome risks in interbank foreign exchange. Its formation followed a Group of 20 recommendation for a continuously linked settlement bank to drive out all settlement risk.
The G-20 effort was in part a response to the 1996 Allsopp Report, known as the "Orange Book," which was issued by the Bank for International Settlements and the central banks of the Group of 10 industrialized nations and Switzerland.
The report called for the private sector to develop a risk-free foreign exchange system.
CLS Service's proposition was to link with the real-time gross settlement systems of various central banks around the world. Transactions would be posted and settled on the books of CLS Bank in real time and in central bank funds.
The risk to a bank is the possibility that its counterparty may fail before the settlement of a currency deal is completed. The hazard is sometimes referred to as Herstatt risk, named for Bankhaus Herstatt of Cologne, Germany, which failed in 1974, setting off a chain reaction of foreign exchange settlement problems around the world.
The advancement of technology in recent years has led to bilateral and, more recently, multilateral netting schemes such as Exchange Clearing House Ltd., or Echo, and Multinet International Bank. But they have not eradicated all Herstatt risk.
London-based Echo is an initiative of major European banks, in operation since 1995. Multinet, owned by Chase Manhattan Corp., First Chicago NBD Corp., and the major Canadian banks, formed in 1989. These two entities merged with CLS in 1997 after struggling to build foreign exchange volume on their own.
IBM Global Services, the computer services and outsourcing unit of Armonk, N.Y.-based International Business Machines Corp., would run CLS Bank from its data centers for five years.
IBM beat out Electronic Data Systems Corp., Plano, Tex., and British Telecom for the deal.
"It was a tough choice," said Larry V. Recknagel, chief executive officer of CLS Services. "All three organizations were pretty competitive."
IBM's Belgium-based operation, which developed Euroclear, a securities clearing and settlement system, has been given the job of making CLS Bank a reality. Big Blue is collaborating with Atos, a France-based systems integrator, and hopes to develop software for testing by next year.
"The game plan is to get the first banks up and running in the middle of 2000," Mr. Recknagel said.
Clay Simpson, senior vice president of payments system risk at BankAmerica and head of marketing for CLS Services, said the organization is offering major foreign exchange banks the opportunity to become equity owners of the proposed bank.
Mr. Simpson said owner banks could sell participatory services to correspondent banks and corporate customers in all the currencies supported by CLS Bank.
"We would, in essence, stand behind our customers and take responsibility for their settlement," Mr. Simpson said.
Still unclear is the role for FX Net, a London-based bilateral netting service for banks, and the system of choice for foreign exchange trading.
"We think FX Net is an important channel for bilateral netting, particularly among large banks," Mr. Simpson said. "We will be talking to FX Net about how they can integrate its services into CLS."
FX Net officials could not be reached for comment.
FX Net's low transaction charges-about $8 per side-would be tough to compete with, considering the system is used for most of the world's $3.5 trillion daily foreign exchange trades.
CLS officials have not decided what to charge participants for using the system. Mr. Simpson said the question boils down to "What do we charge ourselves?"
The reliance on Swift for network communications may also be an issue-or so it is for one payments system expert, who requested anonymity.
This official criticized CLS for not developing a controllable, proprietary networking system that could become compatible with Swift.
Also troubling to this source is that the Swift cooperative, also based in Belgium, is concurrently involved with other major payment systems. For example, it has pacts with Target, the real-time gross settlement system under development for the euro, and with several other national real-time gross settlement systems around the world.
"Too much reliance on one vendor could cause a worldwide economic crisis worse than Herstatt if it went down," the payments official said.
Ernest Patrikis, first vice president with the Federal Reserve Bank of New York, dismissed that concern. He said Swift management is doing an increasingly better job at making sure it can perform its various payment functions adequately.
"Swift is the major telecommunications system for multinational businesses doing business cross-border," Mr. Patrikis said.
"Those are issues that are always on the table." he added. "We have an arrangement in place to keep up with those things."