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How does CLS reduce Herstatt Risk?

How does CLS reduce Herstatt Risk?

What is Herstatt Risk?

Herstatt risk is the risk of loss in settlement of foreign exchange transactions i.e. when one party honors the contract by delivering foreign exchange but the counterparty fails to deliver from its end. This is also referred to as settlement risk or cross-currency settlement risk. It arises when the working hours of interbank are different due to the time zone difference. Settlement risk focuses on all kinds of settlements whereas, the Herstatt risk was referred for foreign exchange or cross-currency settlements. It was named after a German bank Bankhaus Herstatt, which collapsed in 1974 due to insolvency.

History of the Herstatt Bank

Herstatt was founded in 1956 by Iwan Herstatt. In 1973, Herstatt’s total assets were DM 2.07 billion and it was the 35th largest bank in Germany. During the period 1973-74, the US dollar faced a lot of volatility. The bank made bets on US dollar depreciation but dollar appreciated. In the later period of 1973, the bank changed its strategy and placed a bet on appreciation of the dollar. The dollar movement changed at the beginning of the year 1974 it started depreciating. Due to this, the bank faced severe losses. Herstatt’s debts were four times higher than its capital.

In March 1974, a special audit was authorized by the Federal Banking Supervisory Office (BAKred) and it was discovered that Herstatt had open positions amounting to DM 2 billion, against the bank limit of DM 25 million.

In June 1974, some counterparties had already transferred the Deutsche mark considering they will receive US dollars by end of the day. But Herstatt stopped all dollar payments at 16.30 hrs German time when the bank closed and in New York it was 10.30hrs thereby, leaving the counterparties unable to collect their US dollars. The bank had accumulated DM 470 million in losses, as compared to its capital of DM 44 million. On 26th June 1974, the regulators had withdrawn the bank’s license as the income was less than the capital and it couldn’t cover the liabilities. Bank’s assets were DM 1 billion against liabilities of DM 2.2 billion.

The flawed forecasting and less rigorous internal controls led to a huge exposure of more than DM 25 million. Hence, it can be concluded that the other banks dealing with Herstatt were exposed to operational risk.

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What is CLS?

To reduce the Herstatt risk Continuously Linked Settlement (CLS) was introduced. It eliminates time difference in settlement thereby, creating a safer environment in forex transactions.

For example:

In diagram 1 below, Bank A is buying USD and lending JPY, and Bank B is buying JPY and selling USD. For Bank A CLS will swap dollar for yen and Bank B yen for dollar.

In diagram 2 below, Bank B buys JPY and sells USD. In this case, CLS will swap yen for dollar with liquidity provider in Tokyo and give yen to Bank B.

CLS will pay for the bought currency only if the sold currency is received. It uses Payment versus Payment method i.e. payment will be done, only when it is received. (In diagram 2) If the counterparty fails i.e. Bank A, then CLS will return the entire USD to Bank B.

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Mitigation of Risk

Settlement risk can be mitigated through – Delivery versus payment, settlement through clearinghouses, settling foreign exchange via special purpose entity.

I. Delivery versus payment method

  • Huge losses can be incurred because of settlement risk. To minimize the loss one of the methods is delivery versus payment method, also known as DVP.
  • In this method, one party delivers security and at the same time, the other party also has to deliver security. There is no wait time.
  • Both the transactions take place at the same time because of which there is no counterparty risk. If one party fails to deliver security then the other party needs not deliver thereby, mitigating settlement risk.

II. Central counterparty clearing

  • The other method to minimize the settlement risk is through central counterparty clearing known as Central Counterparty (CCP).
  • A CCP is an intermediary that provides clearing and settlement services. A CCP does clearing by netting and offsetting transactions.
  • There are certain requirements of CCP before a transaction takes place such as collateral deposit, provide a guarantor, etc. These requirements have to be adhered to because in case the counterparty fails to perform then it will be used to cover the losses.

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III. Settlement through CLS

  • It is a cross-border payment system that uses a payment-versus-payment mechanism, real-time gross settlement (RTGS), and multilateral netting for the settlement of foreign exchange trades which in turn eliminates settlement risk.
  • Each counterparty will have a multicurrency account with CLS. The parties can perform trade or exchange transactions. The Bank creates a 5-hours window when all the real-time gross settlement (RTGS) are open for all currencies to make and receive payments.
  • This ensures the simultaneous settlement of payments of forex transactions. Settlement members pay and receive through CLS banks via their accounts or through the Nostro bank account. If settlement fails, then the currencies deposited will be returned to the initiating party.

The following currencies can be settled in the CLS system:

  • Australian dollar (AUD)
  • Israeli shekel (ILS)
  • South African rand (ZAR)
  • British pound sterling (GBP)
  • Japanese yen (JPY)
  • Singapore dollar (SGD)
  • The Canadian dollar (CAD)
  • South Korean won (KRW)
  • Swedish krona (SEK)
  • Danish krone (DKK)
  • Mexican peso (MXN)
  • Swiss franc (CHF)
  • Euro (EUR)
  • New Zealand dollar (NZD)
  • United States dollar (USD)
  • Hong Kong dollar (HKD)
  • Norwegian krone (NOK)
  • Hungarian forint (HUF)

Author: Swati Krishnamurthy

About the Author:

Swati is a freelance writer. She is a Financial Quality Compliance Specialist having integrated knowledge and experience in Logistics, Audit, and Risk-mitigation for manufacturing and service sectors. Her passion for finance grew as she scored centum in financial management during her master’s degree. She’s a classical dancer who performs to express complex emotions through her dancing and writes to express complex concepts into simple words.

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