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Focus on the CLS Settlement System for Foreign Exchange Transactions

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Focus on the CLS Settlement System for Foreign Exchange Transactions CHAPTER 9 Systems operating on a payment versus payment basis: focus on the CLS settlement system for foreign exchange transactions Updated on 17 December 2018 CHAPter 9 SYSTEMS OPERATING ON A PAYMENT VERSUS PAYMENT BASIS: FOCUS ON THE CLS SETTLEMENT SYSTEM FOR FOREIGN EXCHANGE TRANSACTIONS his chapter deals with settlement on trade) in exchange for receiving dollars (the a “payment versus payment” (PvP) “dollar leg”). At the same time, Bank Y must T basis, focusing particularly on the CLS deliver dollars to Bank X and will receive (Continuous Linked Settlement) system, euros in exchange. which is used to settle foreign exchange transactions on a PvP basis, currently in Traditionally, each leg of a foreign exchange 18 eligible currencies. After addressing the transaction was settled separately need to manage settlement risk in foreign and independently, using a network exchange transactions (section 1), we go of correspondent banks (with each on to present the CLS system (sections counterparty to the transaction using its 2 to 4). What makes a PvP system like correspondents in the currencies involved) CLS different is that it offsets positions and interbank payment systems in the in different currencies against each other currencies concerned. Under this system, and completes the final stage of foreign settlement is generally not simultaneous, exchange transactions. given in particular the different time zones involved and differing local banking practices for cross-border payments. 1. The need to manage settlement risk in foreign Each of the counterparties to the transaction, exchange transactions Bank X and Bank Y, is exposed to settlement risk vis-à-vis the other. Settlement risk 1.1. Settlement risk in foreign arises as soon as the payment instruction exchange transactions for the currency sold becomes irrevocable, i.e. when it can no longer be cancelled Settlement risk in foreign exchange unilaterally. It ends with the final and transactions is defined as the risk of irrevocable receipt of payment for the delivering the currency sold without receiving currency purchased. Several hours can lapse the currency purchased (or vice versa). between the irrevocable payment in EUR by Let’s consider an example where Bank X Bank X and the irrevocable corresponding and Bank Y are counterparties in a payment in USD by Bank Y. dollar (USD)/euro (EUR) foreign exchange transaction. Bank X is selling euros to Bank Y A foreign exchange transaction thus carries in exchange for dollars. It must therefore not only risk arising from exchange rate deliver euros to Bank Y (the “euro leg” of the fluctuations (market risk), but also settlement Box 1: Settlement of a foreign exchange transaction using the traditional network of correspondent banks and interbank payment systems in the currencies concerned EUR Bank X (or its Bank Y (or its EUR correspondent) via an interbank EUR correspondent) payment system Bank X Bank Y via an interbank Bank X (or its payment system Bank Y (or its USD correspondent) USD correspondent) USD 130 – Payments and market infrastructures in the digital era SYSTEMS OPERATING ON A PAYMENT VERSUS PAYMENT BASIS: CHAPter 9 FOCUS ON THE CLS SETTLEMENT SYSTEM FOR FOREIGN EXCHANGE TRANSACTIONS risk, which has two components: principal T1: Losses sustained by some London banks as a result of risk and replacement cost risk. Principal Herstatt’s failure risk materialises in the event of a definitive (USD millions) default by one of the two counterparties: the Williams and Glyn’s 9 (deposits) non-defaulting counterparty has delivered Chase Manhattan 5 (swaps) the currency that it sold, but has not Moscow Norodny 365 (swaps) received the currency that it bought. In this Union Bank of Switzerland 25 (swaps) situation, the amount at risk is not a portion Hill Samuel 21 (swaps) of the transaction’s underlying value but its United Bank of Kuwait 190 (swaps) principal, i.e. the trade’s nominal amount, or First Wisconsin National Bank of Milwaukee 10 (swaps) the total amount of the currency purchased. Antony Gibbs 1.25 (swaps) Replacement cost risk materialises in the Source: Catherine R. Schenk (2014). event of a temporary default by one of the two counterparties: the non-defaulting counterparty must replace the initial trade through the system plunged almost 60%3 with a new trade at the prevailing market over the following days and the settlement price, which could prove costlier. In the rest of interbank transactions was affected 1 Following this incident, of this chapter, the term “settlement risk” for several months. Confidence in the settlement risk refers to principal risk. foreign exchange market rapidly began to commonly became 4 known as “Herstatt risk” crumble, interest rates in the eurodollar in the banking industry. A historical episode that highlighted market surged and international banking 2 Clearing House Inter- settlement risk on foreign exchange activity contracted as banks around the bank Payment Systems transactions took place on 26 June 1974, world repatriated their assets. (CHIPS) was launched 1 in April 1970, when nine with the failure of German bank Herstatt. large US banks joined Although small in size, the bank was very 1.2. Measures taken by central banks forces to form a major active in the foreign exchange market. and the banking industry to system for the settle- ment of international On the day in question, it was forced into mitigate settlement risk transactions in USD (for liquidation by the German regulator at more details on the CHIPS 15:30 CET (central European time). Earlier Given the increasing amounts traded system, see Chapter 8). that day, several of its counterparties daily in the foreign exchange market, 3 See Berger A. Molyneux P. and Wilson J.O.S (2015). had issued irrevocable instructions for settlement risk on foreign exchange 4 Several small banks were payment in Deutsche Marks (DEM), but transactions was a particular concern squeezed out of the had not yet received the countervalue in for central banks, due to its potentially foreign exchange market dollars (USD) because the US financial systemic effect. In the 1980s and 1990s, and, following Herstatt’s failure, clearing banks in markets had just opened. When the bank’s the G10 countries’ central banks carried New York introduced a liquidation was announced, its New York out a number of studies on the systems “recall of funds” clause, reserving the right to correspondent (Chase Manhattan Bank) in use for cross-border and multi-currency recall funds transferred immediately suspended all payments in payments. The first report published was to correspondent banks USD owed by Herstatt, thus causing the the Lamfalussy report5 in 1990, which until 10:00 (EST) the following day. bank’s counterparties, who were owed contained a recommendation to “continue 5 Report of the Committee USD because they had already paid the to review possible measures that central on Interbank Netting corresponding amounts in DEM, to incur banks might take to improve efficiency and Schemes of the losses. Other banks refused to issue reduce risks in the settlement of cross- G10 central banks (1990). For more details on the payment instructions before receiving border and multi-currency transactions”. Lamfalussy report, see confirmation of receipt of the countervalue. The second report was the Noël report,6 Chapter 18. Despite the German bank’s small size, published in 1993. As a follow-up to 6 Central bank payment its closure triggered major disruption in the Lamfalussy report, the Noël report and settlement services with respect to payment systems and the foreign exchange examined the services that central banks cross-border and multi- market. For fear of further bankruptcies, could consider providing to mitigate the currency transactions 2 (September 1993) https:// the US payment system (CHIPS ) was risks and increase the efficiency of cross- www.bis.org/cpmi/publ/ suspended. The value of transactions border and multi-currency transactions. d07.pdf Payments and market infrastructures in the digital era – 131 CHAPter 9 SYSTEMS OPERATING ON A PAYMENT VERSUS PAYMENT BASIS: FOCUS ON THE CLS SETTLEMENT SYSTEM FOR FOREIGN EXCHANGE TRANSACTIONS The risks in question related to the fact to settlement risk can effectively last for that the two legs of a foreign exchange up to several days,8 which means that the transaction required the use of different total exposure - sometimes to a single payment systems for each currency counterparty - could equal, or even exceed, involved. The report examined and an institution’s equity capital. In view of assessed the following four options: (i) this, the Allsopp report recommended a 7 Settlement risk in foreign modifying or making available certain three-pronged strategy: exchange transactions : home-currency payment and settlement https://www.bis.org/cpmi/ publ/d17.pdf services, (ii) extending the opening hours of • action by individual banks to improve 8 Contrary to the generally home-currency large-value funds transfer the measurement and management of accepted idea that systems, (iii) establishing cross-border settlement risk associated with foreign settlement risk on foreign operational links between these payment exchange transactions; exchange transactions is simply linked to time systems, (iv) developing multi-currency zone differences and payment and settlement services. Without • action by industry groups (i.e. the thus lasts no more than a few hours and stating a preferred option, the report private sector), which are encouraged only applies to the recommended that each central bank to devise and implement “risk-reducing counterparty adversely assess the implications of each option in multi-currency services»; affected by the time lag, the Allsopp report the light of monetary policy, the adequacy showed that settlement of private sector sources of liquidity to • action by central banks to foster rapid risk on foreign exchange transactions generally cover settlements in each currency, and private sector progress and, where lasted for several days.
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