Designed to guard against payments crises, CLS (Continuous Linked Settlement), came online almost a year to the day after what might have been a serious financial crisis following the September 11 attacks, but for prompt action by the Federal Reserve.
The system, which was five years in the making, provides a live link between central bank payment systems in the world’s main financial centers, reducing the chance of a gridlock in the $1.2 trillion daily foreign exchange market, according to Reuters.
The September 11attacks highlighted concerns about the time lag between carrying out and settling currency deals.
However, CLS, a private sector initiative, was actually set up in response to pressure from central banks to remove so-called Herstatt risk, named after the failure of German bank I.D. Herstatt in 1974. The ensuing chain reaction of unpaid deals after the bank shut down disrupted the US payment system for days.
Foreign exchange deals pose a unique risk to national payment systems because their settlement takes at least two working days due to time zone differences.
During that period banks are financially exposed – having paid out a currency they are selling before they receive the currency they have bought. Reuters notes that, in many cases, banks’ exposure to a single party exceeds their entire capital.
With CLS instead of two days to settle currency transactions, there will be a five-hour window, between 0700 and 1200 Central European Time (currently 0500-1000 GMT), for each side of the trade to be settled simultaneously.
CLS is backed by 66 of the world’s largest banks, but only 39 of the banks are ready to start using the system this week, according to the report.
However, CLS says the service will expand to include 12 more of its shareholder, or settlement, banks, and customer banks of settlement banks by the end of the year. Existing settlement members account for roughly 80% of the foreign exchange market in volume terms.
Banks paid around $5 million to become CLS shareholders, but that price will rise, according to CLS. Additionally, internal costs in linking to the system could also be $5 million, industry participants told Reuters – and settlement members will have to pay transaction fees to use the system.
CLS says it has retained bank support because banks feared the alternative would be an increase in the amount of capital they would need to set aside to cover settlement risk.
CLS is based in New York but operates out of London. It will start operating in seven currencies: US dollars, euros, yen, sterling, Swiss francs, Canadian and Australian dollars, and has approval from all the relevant central banks.
Swedish, Danish and Norwegian crowns are likely to be added next year, with the Singapore dollar, Hong Kong and New Zealand dollars considered candidates for 2004, according to the report.