Settling foreign exchange (FX) trades has always been complicated and risky. For example, trades may involve volatile currencies, fluctuating exchange rates, different time zones, and the time lag between paying in one currency and receiving in the other, known as “temporal” risk.

Fortunately, a new system introduced 2002, is taking much of the risk, expense and difficulty out of foreign exchange settlement. This system is called Continuous Linked Settlement (CLS).

The Need for CLS

Global FX transactions have been increasing year after year, currently reaching an average of nearly $2 trillion daily. Although transaction volumes have been steadily rising, they have been settled in the same manner for 300 years.

Until the arrival of CLS, each side of a trade transaction was paid separately. And time-zone differences increased the risk of default. The most momentous and expensive FX trade default, which became the rallying cry for settlement reform, occurred in 1974. The German Bank, Bankhaus Herstatt, failed and was closed before U.S. dollar counterparties could be paid.

How CLS Works

With the real-time CLS system, both sides of a trade are settled simultaneously on a payment vs. payment (PVP) basis regardless of time zones. If both sides of an FX trade do not settle simultaneously, the trade doesn’t settle at all. However, when both sides settle at the same time, CLS provides real-time payment rather than intra-day settlement, virtually eliminating temporal risk.

The CLS service is provided by CLS Bank International, which is owned by nearly 70 of the world’s largest financial groups throughout the U.S., Europe and Asia Pacific. CLS currently deals in the Australian, Canadian and U.S. dollar; the euro; the Japanese yen; the British pound; and Swiss franc.

Direct access to CLS is available only to settlement members, who must have invested in CLS and be a shareholder of the CLS Group. CLS links the clearing systems of seven central banks for five of the overlapping business hours each day (three hours in Asia Pacific) of the participating settlement members. During this time:

  • Settlement members submit settlement instructions directly to CLS Bank for processing.
  • Settlement members pay in the net funds at the relevant central bank.
  • CLS Bank continuously receives funds from members, settles instructions and pays out funds to members until all instructions are settled.
  • Trades that can’t settle immediately are returned to the queue and are continually revisited until they settle.
  • If there are no problems, all funds are disbursed back to settlement members.
  • If the strict settlement criteria are not met for each side of a trade, it’s not settled and no funds are exchanged.

Using CLS As a Non-Member

It’s possible to enjoy the advantages of CLS as a third party, sponsored by a CLS Bank member who acts on your behalf. As a third-party user, you can expand your FX business and trade capacity, manage global liquidity more efficiently, leverage multi-currency accounts, and reduce your payment volume and cash-clearing costs — without the costly investment in CLS or the demands of a 24-hour operation.

In a third-party arrangement, the CLS Bank member is responsible for paying the time-sensitive funds, which are consolidated in CLS. The third party then reimburses the member later in the settlement day or settles accounts according to a bilateral agreement. It’s easy to participate as a third party. All you need is a standard web browser with regular SWIFT connectivity to send trade instructions or check the status of your trades.

Choosing a CLS Provider

Many banks, investment funds, non-banking financial institutions, and corporations are offering the CLS service to their customers. A large number of these are third parties themselves, who participate indirectly as customers of settlement members. If you’re considering participating in CLS as a third party, you’ll want to ensure that your provider has a global presence, expertise in processing payments and managing liquidity in all currencies, and 24-hour real-time systems in place to handle all the processing, reporting, customer service and other issues involved in CLS.

This article appeared in Crain's Detroit Business, July 2003. (CO)
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John Manzella
About The Author John Manzella [Full Bio]
John Manzella, founder of the ManzellaReport.com, is a world-recognized speaker, author of several books, and a nationally syndicated columnist on global business, trade policy, and economic trends. His latest book is Global America: Understanding Global and Economic Trends and How To Ensure Competitiveness.




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