Continuous link settlement system

Foreign exchange settlement presents a risk of one party defaulting before a transaction has been completed, because settlement takes place through accounts in the correspondent banks in the countries where the relevant currencies are issued.

Because the various national payment systems are located in different time zones around the world, one side of a foreign exchange transaction will likely be settled before the other side of the transaction. For example, dollar payments are settled later than euro payments, which in turn are settled later than yen payments. Thus, someone buying in dollars and paying in euros will have settled the euro side of the payment before receiving any dollars. If the counterparty were to fail in the midst of this transaction, the transaction initiator would have paid dollars but lost the offsetting euros. This risk is called settlement risk.

To avoid this settlement risk while also speeding up the settlement process, a number of major banks banded together to create the Continuous Link Settlement (CLS) system. The system is operated by CLS Bank International, of which the founding banks are shareholders. Other banks can submit their foreign exchange transactions through these member banks. The following currencies can be settled in the CLS system:

  • Australian dollar
  • Israeli shekel
  • South African rand
  • British pound
  • Japanese yen
  • Singapore dollar
  • Canadian dollar
  • Korean won
  • Swedish krona
  • Danish krone
  • Mexican peso
  • Swiss franc
  • Euro
  • New Zealand dollar
  • U.S. dollar
  • Hong Kong dollar
  • Norwegian krone

CLS maintains an account with the central bank controlling each of the above currencies. Also, each member bank of CLS has its own account with CLS, which is subdivided into a sub-account for each currency. The member banks submit their foreign exchange transactions to CLS, which uses a gross settlement system to debit the account of a participant in one currency, while at the same time crediting its account in a different currency. If a member bank has a net debit position in a particular currency, CLS requires that it have sufficient balances in its other sub-accounts (less a small margin to account for possible fluctuations in exchange rates during the day) to act as collateral for the debit position. If a member bank’s debit position exceeds a pre-set limit, then that bank has to replenish its sub-account in the currency having the debit position.

The CLS settlement process flow is for member banks to send their foreign exchange transaction information to CLS during the day, after which CLS creates a schedule of net payments that the member banks must pay to CLS. CLS then processes both sides of each individual foreign exchange transaction, so that the account of one member bank is debited, while the account of another member bank is credited. CLS processes these transactions on a first-in, first-out basis. If, during the processing sequence, a member bank’s cash position with CLS becomes too low, CLS will shunt aside and postpone its remaining transactions until additional funds are provided by the member bank.

After CLS has completed this process, it transfers the updated balances of the settlements back to the accounts that the member banks hold at the central banks in their home countries. Since these payments are the result of the aggregation of a multitude of smaller transactions, they are on a net basis. This processing period must be completed during a five-hour period that covers the overlapping business hours of the participating national settlement systems.

How does CLS impact the corporation? It gives the treasurer exact information about when settlements will occur in various currencies, which had previously been difficult to predict with precision. With better foreign exchange settlement information, the treasury staff can now optimize its short-term investment strategy.