CLS Bank

CLS Bank

DOI: 10.4018/978-1-61520-645-2.ch012
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Abstract

This chapter focuses on the CLS Bank. CLS Bank International (hereinafter referred to as “CLS Bank”) was established in 1999 to eliminate settlement risk associated with settling foreign exchange (FX) transactions in different time zones. It provides the unique multi-currency Payment versus Payment (“PVP”) settlement service for the major players in the FX market. Although CLS Bank was established as a private bank in the US, the main purpose of the Bank is neither to accept deposits nor to make loans. Its function is dedicated to providing a multi-currency settlement service. Thus it is more appropriate to regard CLS Bank as a kind of payment system, or market infrastructure than just a private bank. This chapter elaborates on the mechanism of CLS Bank, which includes the organization, the shareholders, the eligible currencies, and the accounts used for CLS settlement. The funding and settlement procedures and risk management schemes of CLS Bank are discussed in greater detail. In addition, the impact of CLS Bank to FX settlements and the FX market is also analyzed.
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Introduction

In FX settlements, there is settlement risk arising from settling two currencies in different jurisdictions and often different time zones. That is the risk that one party of a FX transaction pays the currency it sold but does not receive the currency it bought.

For example, the Japanese Yen-leg is settled at Tokyo market in the Japan time zone, the euro-leg is settled in the European time zone, and the US dollar-leg is settled in the US time zone. In the case of transaction between Japanese Yen (JPY) and the US dollar (USD), there is a time-lag between the settlement time of the JPY-leg and that of the USD-leg. Therefore, one party has the risk that it cannot receive the counter value in the USD, even if it delivers the JPY amount.

This kind of settlement risk caused by the time difference is referred to as the “Herstatt risk.” The presence of this risk was widely recognized for the first time by the financial community and regulators in 1974, when Herstatt Bank in Germany was closed on 26th June. Herstatt Bank was ordered the closure at 3:30 p.m. in Frankfurt, after the close of the interbank payment system in Germany. The closure time of the Bank was 10:30 a.m. in New York.

Under such circumstances, the FX counterparts of Herstatt Bank had all paid their Deutsche marks to Herstatt Bank but never received their purchased USD. With the bankruptcy of Herstatt Bank, all the counterparties lost the total value of their FX trades with the Bank (see chapter 3 for more detail).

Similarly, at a later date, some major banks suffered the huge losses when the Bank of Credit and Commerce International (BCCI) went into bankruptcy in 1991. This incident caused the banking community to consider again the gravity of the FX settlement risk.

Since the FX market has grown strongly over fifty years, even if this settlement risk persists for only a short and limited time, the total exposure of the FX trades could be very large compared to the capital of the banks involved in the trade. Usually, the average value per FX transaction is large and can be enormous. The FX settlement risk is not the “Replacement Cost Risk” but the “Principal Risk,” which is a risk that a party will lose the full value of the trade. Therefore, the active banks in the FX market hold significant risk on a day-to-day basis. In some cases, the large banks may have almost three times more exposure to the FX settlement risk than to the credit risk which the banks hold as a whole. The daily settlement exposure reaches tens of billions of dollars constantly. In an extreme case, the exposure of a bank to a single counterparty goes beyond the entire capital of the bank.

There were long discussions about how to cope with the Herstatt risk at the level of central banks, at industry group level, and in the individual banks, respectively. The PVP concept of CLS Bank was derived from these discussions.

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