Continuous Linked Settlement (CLS) is a specialized financial service used in the foreign exchange (FX) market to mitigate settlement risk. This risk, also known as “Herstatt Risk,” arises from the time difference in settlement among different currencies, leading to a scenario where one party in a FX transaction may pay out the currency it sold but not receive the currency it bought.
Definition and Meaning
CLS operates as a sort of multilateral settlement system. It works by simultaneously settling payments on both sides of FX transactions. This process is done in a way that ensures a trade is only finalized if both sides of the deal are funded. If one party fails to deliver the required funds, the entire transaction is unwound, protecting the other party from loss.
Usage
CLS is primarily used in the foreign exchange market, which is one of the largest and most liquid markets in the world. Banks, financial institutions, and multinational corporations are the primary users of CLS. They use this system to settle FX transactions safely and efficiently, minimizing the risk associated with the time lag in completing these trades.
How It Works
- Trade Submission: Parties involved in FX transactions submit their trade details to CLS.
- Matching and Confirmation: CLS matches and confirms the details of these trades, ensuring both sides agree on the terms.
- Payment Instructions: Each party funds its payment in the respective currency to CLS.
- Simultaneous Settlement: CLS simultaneously settles the payments, transferring the sold currency to the buyer and the bought currency to the seller.
Examples
- Example 1: A U.S. bank and a European bank enter into an FX transaction where the U.S. bank buys Euros from the European bank in exchange for U.S. Dollars. Both banks submit their trade details to CLS. On the settlement day, the U.S. bank pays Dollars to CLS, and the European bank pays Euros. CLS then simultaneously delivers Euros to the U.S. bank and Dollars to the European bank.
- Example 2: A Japanese corporation and a Canadian corporation agree to a currency exchange where the Japanese corporation will sell Yen for Canadian Dollars. They use CLS to mitigate settlement risk. Both corporations provide their respective currencies to CLS on the agreed date. CLS then simultaneously settles the transaction, transferring Yen to the Canadian corporation and Canadian Dollars to the Japanese corporation.
In summary, CLS is a critical mechanism in the FX market for reducing settlement risk. Its role in ensuring simultaneous settlement of transactions in different currencies makes it an invaluable tool for international financial operations.
—
This page was last updated on December 2, 2024.
–