Finance

How does Continuous Linked Settlement Work?

What is Continuous Linked Settlement (CLS)?

Continuous Linked Settlement System was introduced to provide settlement services for forex transactions to its participants/members to mitigate settlement risk and help financial markets remain relatively unscathed from systemic risks. CLS helps in the mitigation of risks, does not eliminate them.

Motivations behind the establishment of CLS and its working methodology:

Continuous Linked Settlement was introduced in 2002 post fallout on the potential default of financial liabilities to be honored in forex transactions (German Bank). Forex markets have volumes worth trillions of dollars and the trades represent multi-currency trades with exposure worth much more than real capital. Such trades have to be settled on a regular settlement day.  Foreign exchange transactions take place during multiple time zones and the exchange of currencies doesn’t happen concurrently exposing both parties and financial institutions to potential liquidity, credit, settlement, and systematic risks.

Let’s examine how the introduction of CLS helps forex markets. There’s a party that sold the currency before it received the proceeds from the counterparty. If the counterparty couldn’t honor obligations, the seller party could likely face default risks. CLS helps in mitigating settlement risks by simultaneously transferring funds by the Payment Versus Payment method while keeping liquidity requirements to a reasonable threshold.

Involved parties in forex transactions transfer the amount to CLS and CLS settles both trades simultaneously. When such large amounts are settled, they involve sacrificing huge liquidity in turn affecting daily turnovers as well. CLS comes as a savior in two ways- it helps in gross settlement(acts as an agent)-mitigating settlement risks and only netting of balances of aggregate long/short positions are required to be paid out to parties which reduces liquidity requirements drastically.

CLS settles all transactions during 5 hours window through RTGS when all currency jurisdictions are open. Participant member countries are required to hold multi-currency accounts with CLS for convenient transactional settlements.

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How Foreign Exchange Transactions take place?

Here, Bank A sells Japanese Yen (JPY) to Bank B in exchange for US Dollars (USD) & trades are settled on normal settlement day. Bank A sells JPY & sends instructions to its correspondent bank Ja to send JPY to Bank B’s correspondent bank JB. Bank Ja executes the transaction by debiting Bank A’s account on relevant settlement day & sending Yen to Bank Jb. Bank Jb credits Yen to Bank B’s account & informs Bank B of the arrival of JPY.

In a similar fashion, Bank B instructs its correspondent Bank Ub to send USD to Bank A’s correspondent Bank Ua. Bank Ua credits USD to Bank A & informs the Bank A of the arrival of USD.

How Continuous Linked Settlement (CLS) works?

CLS is a bank for settling FX transactions based in New York with main operations in London. CLS Bank is owned by 69 institutions that happen to have appreciable significance in Foreign Exchange Market. CLS removes principal risk using the Payment Versus Payment (PVP) mechanism. Both banks send its sold currency to CLS bank that acts as an intermediary. CLS will give bought currency only on receipt of delivery of counterparty’s currency which has to be handed over.

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Advantages:

  • CLS has managed to garner a 50% market share of forex transactions settlement. The degree of acceptance across the globe in a few years has been commendable.
  • CLS has helped reduce liquidity requirements drastically and has been effective in the mitigation of settlement risks.
  • CLS could effectively function during the 2008 Global Financial Crisis & has proved efficacious framework.

Disadvantages:

  • At present, the CLS bank settles transactions of only 17 currencies all over the world. Many currencies have not been part of the CLS settlement system on account of insufficient business volume or costs outweighing benefits.
  • CLS remains exposed to the risk of counterparties facing teething troubles to pay in full settlement margins in case forex volatility breaches historic benchmarks causing extreme exchange rate fluctuations before settlement takes place. In such unfavorable events, loss-sharing agreements among market participants shall help CLS recover losses.

About the Author:

Ashutosh Buch is CFP (FPSB India) & has passed Level-I of CFA Program. His primary interest lies in analyzing investments in primary & secondary markets. At present, he focuses on learning the nuances of financial markets & management consulting. He remains committed to his goal of helping businesses scale up & making them ESG-friendly.

 

Related: How does CLS reduce Herstatt Risk?

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