Overview
This lecture introduces CLS (Continuous Linked Settlement), explaining its crucial role in reducing risks in foreign exchange (FX) transactions and ensuring secure settlements between banks.
What is CLS?
- CLS stands for Continuous Linked Settlement, a clearing house service for foreign exchange (FX) transactions.
- CLS acts as a third-party referee to ensure both parties in a currency trade receive their respective currencies simultaneously.
- The primary goal of CLS is to eliminate settlement and credit risk in FX trades.
CLS Functions & Importance
- CLS guarantees that a seller delivers one currency and simultaneously receives the other, preventing incomplete trades.
- It tracks all trades for risks, particularly monitoring liquidity and the principal amount involved.
- Over 50% of daily FX trading volume, about $4 trillion (out of $7.5 trillion), is settled via CLS.
- CLS operates during a daily 5-hour settlement window when all participating bank systems are open.
- Settlement finality in CLS means once a payment is made, it cannot be reversed, even if a counterparty fails or goes bankrupt.
Settlement Methods
- PVP (Payment Versus Payment): Both sides of an FX trade must settle at the same time, reducing one-sided payment risk.
- RTGS (Real Time Gross Settlement): Payments are processed and settled individually in real time throughout the day.
- Central banks provide intraday liquidity (often via overdrafts and collateral), but liquidity has costs (interest, opportunity cost).
- Central banks, like the Federal Reserve, claim access to unlimited liquidity, thus do not face liquidity risk in settlement systems.
Net Settlement & Algorithms
- In net settlement, banks tally up daily payment requests and settle only net totals at specified times.
- Algorithms are sequences of steps or rules used to efficiently solve problems, such as calculating totals and processing trades.
Unique Challenges in FX Settlement
- FX trades often span different countries and time zones, making simultaneous settlement difficult.
- CLS ensures exchanges only happen when all regional payment systems are open and mitigates time zone risks.
- In Asia-Pacific, the CLS settlement window may be shorter, such as 4 hours.
Significance of CLS in FX Markets
- CLS settles about 50% of global FX trades, approximately $6 trillion daily.
- Post-trade processing (clearing and settlement) is crucial but often overlooked in the industry.
Key Terms & Definitions
- CLS (Continuous Linked Settlement) — Service that settles FX trades, reducing settlement risk.
- FX (Foreign Exchange) — Trading of currencies between banks or institutions.
- Settlement Finality — Completed payment cannot be reversed.
- PVP (Payment Versus Payment) — Settlement system requiring simultaneous payment by both parties.
- RTGS (Real Time Gross Settlement) — Immediate, individual settlement of payments.
- Net Settlement — Settling only net balances at set intervals.
- Algorithm — Finite sequence of steps for calculation or data processing.
Action Items / Next Steps
- Watch part two of the lecture series for coverage of CLS, RTGS, time zones, and split orders.