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Page last updated
February 16, 2003




Continuous Linked Settlement - reshaping global FX


The financial industry as a whole finds itself in a rapidly moving environment at the eve of the new millennium. It is not only the internet and e-commerce opportunities which reshape banking but also the introduction of concepts like Continuous Linked Settlement Services (CLSS), which will have a profound impact on the way foreign exchange business will be conducted.

Continuous Linked Settlement (CLS) was founded with the intention that settlement risk, which is inherent to all foreign exchange transaction due to the current processes, is eliminated. In order to achieve this goal a 'payment-versus-payment' scheme was introduced, i.e. both legs of a foreign exchange transaction are paid simultaneously. This is very close to the delivery-versus-payment concept in the securities world.

In its report on settlement risk in Foreign Exchange Transactions from March 1996, the Bank of International Settlements defines settlements risk as follows:

"At its core, settlement of a foreign exchange (FX) trade requires the payment of one currency and the receipt of another. In the absence of a settlement arrangement that ensures that the final transfer of one currency will occur if and only if the final transfer of the other currency also occurs, one party to an FX trade could pay out the currency it sold but not receive the currency it bought. This principal risk in the settlement of foreign exchange transactions is variously called foreign exchange settlement risk or cross-currency settlement risk."

Another risk associated with settlement risk is liquidity risk. It can be differentiated into two forms: market liquidity risk which arises when a firm is unable to conclude a large transaction in a particular instrument at anything near the current market price and funding liquidity risk which is defined as the inability to obtain funds to meet cashflow obligations.

The second dimension to settlement risk is an associated credit risk. If a transaction can not be settled the party which paid out first faces the risk of fully losing the principal amount of the transaction. The party's exposure equals the full amount.

Awareness of settlement risk and its potential effects on global markets was created in 1974 through the failure of Bankhaus Herstatt, a small Foreign Exchange trading bank in Germany. During the banking day the bank's banking licence was withdrawn, and it was ordered into liquidation from the German authorities. This happened after the close of the German interbank payments system. At that time some of Herstatt Bank's counterparties had irrevocably paid DeutscheMark to the bank during the day but before the banking licence was withdrawn. They had done so in good faith anticipating the receipt of US dollars later in the same day in New York. Herstatt's New York correspondent bank suspended all outgoing US dollar payments from Herstatt's account. This lead to a full exposure of the counterparties to the value of traded German marks.

'Herstatt Risk' was the term coined to describe this kind of settlement risk. It occurs when one party pays out the currency it has sold but does not receive the currency it has bought. It is however an inappropriate term since it has materialised in other cases and under differing circumstances. Other examples include the failure of US investment bank Drexel Burnham Lambert in 1990 and the famous Barings case in 1995. A more precise definition for 'Herstatt-Risk' would be cross-currency settlement or foreign exchange settlement risk. The value at risk corresponds to the full amount of currency purchased. The time frame a bank is exposed to this risk lasts from the time that an unilateral rescind of the currency sold is not possible any more until the time the currency purchased is received irrevocably.

Central Banks became more and more interested and concerned about the potential disruptive consequences on financial markets due to settlement risk. In the 1990s the daily volume of global Foreign Exchange trading reached the present level of USD3trn. Against that background the Bank for International Settlement published in 1993 the Noel Report and in 1996 the Allsopp Report. The Noel Report outlined the fundamental concept of multi-currency delivery-versus-payment (DVP) schemes. DVP means that the final transfer of one asset occurs only if the final transfer of another asset occurs. This creates the concept of linked transactions. With the publication of the Allsopp Report, in which a three-way strategy was suggested to handle settlement risk a generally accepted practical way to tackle this issue was available. This report accelerated the private initiative of a group of major foreign exchange trading banks.

The birth of CLS
In 1995 a group of major FX trading banks (known as the Group of 20 or G20 with UBS as a major participant) got together to consider how the private sector might develop a solution to the problem of settlement risk. The result of this study was the CLS concept. In July 1997 the G20 banks formed a company, CLS Services Ltd (CLSS), to develop and build the CLS system.

In December 1997 CLSS acquired the share capital of ECHO and Multinet International Bank (MIB) to create a single industry facility to reduce settlement risk and pre-settlement risk in the foreign currency markets.

The initial shareholders of CLSS were the G20 banks. Additional banks became CLSS shareholders when ECHO and MIB were acquired. CLSS ownership is open to qualified financial institutions who meet the criteria, This yet to be defined, but may include capital, credit rating, ability to meet funding requirements and operational competence. Currently, CLSS has 62 shareholders from 14 countries.

Membership in CLS
CLS Bank differentiates between Settlement Members and User Members.

Settlement Members maintain accounts with CLS Bank in the eligible CLS currencies and can directly submit trades to CLS.

In order to become a settlement member the capital, credit rating, funding capabilities and operational requirements must be met. Settlement Members are nominated by CLS Shareholders which requires that the potential Settlement Member is either a CLS Shareholder or a fully owned affiliate of the CLS Shareholder. In most cases the CLS Shareholder is also the settlement member.

Each member is responsible for the net funding obligations of all submitted transactions. Additionally each member must nominate a control branch that is responsible for maintaining the settlement account with CLS Bank and all resulting operational and funding consequences. It receives all notifications issued by CLS Bank to its settlement members. Multiple control branches are allowed as long as only one is active. Only the active control branch will receive notifications from CLS Bank. All other branches are organised as standard branches.

User members have no direct accounting relationship with CLS Bank. They are able to submit trades directly to CLS but they have to rely on a settlement member to settle their transaction over CLS. A User Member may have arrangements with more than one settlement member for sponsoring transactions. Those settlement members must be able to control the credit and liquidity exposures of its user members. As a result user members also have no control branch vis-a-vis CLS Bank.

Both memberships enable direct submission of trades also for non-members, which are also known as third parties. CLS members can carry out settlement on behalf of third parties. These transactions are in the direct responsibility of the particular CLS member that submitted the transactions. As with user member, a settlement member must be able to fund the transaction of its third party client. How a settlement member and a third party settle their obligations against each other is subject to an internal agreement between these two parties.

Additionally there are two important parties in the CLS environment. For all settlement members, that have no direct access to a CLS currency real-time gross settlement system (RTGS) so called nostro agents fill the gap. These agents are able to effect payments to and receive payments from CLS Bank on behalf of a settlement member according to CLS rules. Their role is very close to the role of classic nostro agents except that they must be able to make time based payments ordered from a settlement member to CLS Bank. This requires that a nostro agent must have the capability to fund payment orders in favour CLS Bank.

Settlement in the CLS environment
Liquidity Providers play another important role. They become active if one of the settlement members does not meet his settlement obligations and ensure a smooth settlement process during the settlement cycle. However a failure of a settlement member will be penalised by CLS Bank. Therefore liquidity providers will only be active in emergency situations.

The current process for foreign exchange transaction is straightforward. If two parties agree on a deal they exchange confirmations to 'confirm' the trade details like currency, value date, exchange rate and amount. Usually they have auto-matching capabilities to reconcile the confirmation of the counterparty against their own trade details. At value date both parties issue a payment order to meet the obligation generated through this trade. The payment orders are released some time during the value and before the cut-off times of the corresponding clearing systems or nostro agents. The payments are most likely made at different times which is even more pronounced if time zones are involved.

Although these transactions (selling one currency and buying the notional of a counter-currency) are linked, their execution is not. They are executed at different times of the value date. And this creates settlement risk.

CLS provides a mechanism to take into account the linkage of these transactions. For this purpose each settlement member has accounts in all CLS eligible currencies. If a settlement member agrees on a Foreign Exchange transaction with another Settlement Member or User Member they will still exchange confirmations. Additionally a copy of both confirmations is submitted to CLS Bank which will match them and book the appropriate settlement accounts at CLS Bank. Settlement members can retrieve the status of the submitted trades at CLS Bank.

Transactions for the same value date and for each CLS currency are netted on the settlement accounts and create a balance in each CLS currency for each settlement member. CLS Bank has introduced two constraints to risk manage the resulting positions. Each account has a short Position limit (SPL) and the sum of all positions must not undercut an aggregate short position limit (ASPL) which is smaller than the sum of all SPL. Additionally the overall position of each settlement member must be positive. Settlement of the submitted transactions occurs across the settlement accounts. If for example Bank A sells CHF and buys US$ from Bank B then Bank A's CHF settlement account will be debited and the US$ settlement account will be credited; vice versa for Bank B. These two steps take place at the same time, which corresponds with the payment-versus-payment concept and thus reflects the linked nature of those transactions.

In order to start the settlement process settlement members are asked at beginning of the settlement day to pay to CLS Bank at least the amounts which are under the corresponding SPL. The total amount is split into several tranches during the CLS settlement day. In Central Europe a maximum of five payments can be expected. As soon as the first pay-in payments are made so called pay-out payments resulting from positive balances can be expected. Each settlement member knows at the beginning of the settlement day how much money it can expect. However CLS those payments are split and will be pay to settlement members during the whole settlement day.

A normal CLS Settlement Day starts with the generation of a so called pay-in schedule by CLS Bank at midnight of the value date. CLS Bank basically simulates the settlement day and calculates the liquidity needs for each settlement member. The schedule contains information about the time and the amount for a particular pay-in payment, i.e. each settlement member has to issue a payment order at a specified time.

After receiving the pay-in schedule settlement banks can start to fund themselves. At 06.30hrs CET, CLS Bank releases the final pay-in schedule which takes into eventual account same day trades.

The control branch must ensure that the payments are made on time with the correct amount.

After the first pay-in payment at 08.00hrs CET, the first pay-out payments from CLS Bank can be expected. These payments

are not time-based unlike the pay-in payments. The control branch monitors all other pay-in payments and records the incoming pay-out payments during the whole settlement day.

At the end of the settlement day transactions and payments are reconciled against each other. CLS Bank sends a statement to each control branch.

Launching CLS
The current timetable calls for operational trials to start in the second quarter of 2000 and takes four to five months. The trials are essentially scripted tests and serve different purposes:

n Prove to regulatory bodies that the CLS concept works;

n For trial members to become CLS compliant; and

n For trial members to streamline their CLS processes.

The scripted tests will run in a productive environment.

After the operational trials the planned live date is during September 2001. Also, September 2001 two new currencies will be included in CLS. the Australian dollar and Japanese yen will be introduced to the CLS currency club.

Settlement risk of foreign exchange deals in the eligible CLS currencies. As a consequence provisions taken to cover losses through settlement risk can be lowered. Settlement risk still exists for non-CLS banks. It is therefore expected that banks which do not want to invest to or cannot become a CLS member look for means and services to have access to CLS and perform foreign exchange transactions free of settlement risk.

As the deals are settled across CLS's books and only net position are relevant it follows that thousands of deals can be settled with a very limited number of payment orders issued from the settlement members. This will lower transaction costs for banks considerably. Indirectly, operational risk is lowered because fewer payments will be generated and therefore fewer errors can occur in processing them.

CLS over time will be expected to reduce the volume of transactions cleared through the relevant national RTGS system; this will affect the profitability of the 'vanilla' currency clearing business and cause banks to expand the range of services offered. Current estimates project a 30% decrease in number of transactions.

An interesting aspect of the introduction of CLS is the focus on time-based payments. It is mandatory for settlement members to pay at certain daily times certain amounts of money in favour of CLS. This leads to intra-day value of liquidity and will trigger the development of time-based financial products. These new developments will not be confined to the foreign exchange market, and apart from possibly extending to other cash based products must be extended to the securities world in order to support an intraday securities market.

Christian Kronseder
Product & Market Management of UBS AG


Settlement Risk
Background  to CLS
Worth having waited
Global FX
Radical change
3rd Party customers
The Future




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