Profit & Loss, by Galen Stops

As the RMB gains in prominence, China faces decisions around settlement mechanisms, which will be crucial to its acceptance as a truly international currency.

China faces a decision – one that weighs operational risks against political risks: does it join the global market and put its currency onto CLS, the primary settlement system for world currencies, or does it build its own utility?

Trading in CNH continued to surge in 2015, and the currency overtook the Japanese yen to become the fourth largest payments currency and is now to be included in the International Monetary Fund’s (IMF) Special Drawing Rights (SDR) basket. All of this points to China’s currency moving further towards the financial mainstream.

However, there’s one key issue preventing CNH trading from really taking off, and it’s a big one. As discussed on a panel at Profit & Loss Shanghai in November, the currency needs a central settlement mechanism if it is going to be able to live up to its potential.
Out of the top 10 most actively traded currencies in the Bank for International Settlements’ (BIS) 2013 survey, RMB is the only one that is not in the continuous linked settlement system, CLS. Likewise, RMB will be the only currency in the SDR basket not in CLS.
This begs the question of whether 2016 will be the year in which China pushes for some form of its currency to be made CLS eligible.

The Obvious Choice?
CLS is a well-established piece of market infrastructure – deemed in the US as a systemically important utility – and as such, the global FX market relies on it. Moreover, as China seeks to internationalise its currency, there appears to be a strong push from the authorities there towards the financial mainstream.
The importance attached to the SDR basket entry by the Chinese authorities is a clear indication of this. As part of the SDR entry, China will be connected to the IMF in a much more pronounced way, not least in part due to the agreements that it has to abide by in order to have its currency in the SDR basket.
All of this seems to point towards a greater degree of RMB integration into the global financial system, something that would help the eventual internationalisation of the currency. It would seem strange, therefore, for China not to use the established settlement infrastructure that is already connected to, and used by, so many firms across the world.
Another potential benefit of CLS inclusion is that being accepted for its settlement service confers a certain status upon that currency as one that is safer for market participants to trade, given the criteria that a currency has to meet to become eligible for its settlement service.

Regulatory Considerations
However, despite the benefits of having its currency made CLS eligible, some market participants suggest that China may be considering another path. Although CLS has an oversight committee that includes all of the central banks whose currencies are settled by CLS, the US Federal Reserve is the regulator of the legal entity and acts as the lead overseer of the settlement utility. This, according to some, could prove to be a sticking point for the Chinese authorities in adopting CLS for settlement services.

Jon Vollemaere, CEO and founder of R5FX, adds: “I don’t see China tying themselves to a system where the US Federal Reserve is the lead regulator, and why should they? “I know other central banks are on

[CLS’s] oversight committee, but I can’t see China agreeing to join a system where the settlement of the RMB could be potentially outside its control or not reported in a way that the party wants it to be. The operational risks of not joining CLS are overshadowed by the political risk of joining. “I think the word ‘control’ is important. China will always put more importance on the controlled internationalisation of the economy than the ease of foreigners accessing its markets,” he concludes.
Discussing the political element of getting China’s currency into CLS, a senior figure at one trading platform suggests that there could be a concern about geopolitical events scuppering years of development work. Pointing to Russia, the source notes that the inclusion of the ruble into CLS appears to have been put on hold indefinitely as a result of such a geopolitical event, and speculates on whether this could impact the Chinese authorities’ eventual decision on whether to use CLS or build its own third-party settlement system.
David Clark, chairman of the Wholesale Markets Brokers’ Association (WMBA), agrees that the situation in Russia could have a bearing on the Chinese authorities’ decision, especially in conjunction with the political environment in the US.
Although Clark stresses that political friction between the US and China to the point where sanctions are issued is very unlikely, he says that some of the rhetoric coming from the US presidential candidates – particularly concerning issues such as currency manipulation – might concern the Chinese. “I think it’s a genuine risk that the Chinese are right to take seriously. It may be an unlikely buy lexapro 5mg scenario, but if you’re planning the operational risk map for the future of the Chinese currency markets, then this is an existential risk and therefore cannot be ignored,” he says.

Settlement Alternatives
But should the Chinese authorities decide not to head down the path towards CLS eligibility, what are the other settlement options available?
Perhaps the most obvious one is that China could build its own CLS-like settlement system for its currency that international firms would have to connect to if they wanted to use a centralised settlement system.

Vollemaere concedes that it would be much easier for firms outside of China if the RMB became CLS eligible rather than being settled in a new system, but argues that if the world wants to trade this currency, then it will have to connect to whichever system is supported by China.
“I think that China will have its own system. If you want to deal with them, then you do it their way or not at all,” he says. “China has the size and global influence to have its own system, which will likely be similar to CLS, and require the world to come to the Middle Kingdom. Not the other way around.”

But because of the traction that CLS already has in the global FX market, Vollemaere says that even if China builds its own Chinese settlement system then CLS will have a role to play in bridging the gap between the two. He suggests that CLS could develop some type of interface passport between the two systems, enabling firms to choose between accessing the Chinese system directly or through CLS via a form of sponsored access.

Clark, on the other hand, thinks that it is unlikely that China will build its own settlement system for RMB trading. He argues that there are more convenient solutions to the perceived political complications of China using CLS. “I think that there would have to be a lot of international agreement that CLS can not be so handicapped by the US authorities that it would threaten other people’s settlement,” he says.
The point is well made – China is a large enough centre of trade that any hypothetical sanctions that impact RMB settlement would also hit firms in numerous other countries.

Although CLS can’t unilaterally change its corporate governance structure, one possible solution suggested by Clark is that the IMF could help to negotiate some form of international protocol or agreement that provides assurances that CLS won’t be exposed to political pressure. Optionally, Clark says it would be easier for CLS to set up a subsidiary in Asia, which would be regulated locally in Asia, than for China to build its own CLS-like settlement system.

Political Risk vs Operational Risk
Both having a currency become CLS eligible and building one’s own settlement system are intensive processes that will take years. In both cases there are a number of variables that will determine exactly how long that solution will take to implement.

Interestingly, the source at the trading platform suggests that if China decides to make its currency CLS eligible, then it is possible that the time it takes to do so could be reduced if China is able to effectively leverage the experience of the Hong Kong Monetary Authority (HKMA), which has already been through the process of making a currency CLS eligible before.

Not everyone agrees with this suggestion though. “The PBOC’s administration is fundamentally different to HKMA so I don’t think there is an easy template to follow there,” says Du. But in Hong Kong, the PBoC could even find an alternative to CLS, as HKMA is linked to CLS, and it also has a CLS-type functionality for Hong Kong through its RTGS, which has payment versus payment and settlement finality. Although it is only available for HKD and RMB crosses, and it isn’t as big or as efficient as CLS, it offers a viable alternative. And it has one major advantage over CLS: it’s owned by China.

In the end, China faces a decision – one that weighs operational risks against political risks: does it join the global market and put its currency onto the primary settlement system for world currencies or does it build its own utility?

It should be emphasised that this is all just speculation as it currently is not clear in which direction the Chinese authorities will go. But there is growing pressure from both within and without China to internationalise its currency, and having a third party settlement mechanism in place represents an important step in encouraging the global trading of its currency.

The Chinese authorities are not yet at a decisive fork in the road on this issue of settlement, and with recent stock market volatility and continuing developments around capital account deregulation, this is unlikely to be the most pressing topic on their agenda. But it is one that will have a major impact on offshore and, eventually, probably onshore RMB trading too. And as is increasingly the case in the global financial markets, it’s all eyes on China until a decision is made.