The benefits of Continuous Linked Settlement (CLS) in today’s foreign exchange market

How is Continuous Linked Settlement (CLS) useful? And how will it remain relevant in the future?

In 2022, the Continuous Linked Settlement (CLS) Bank celebrated its 20 years of service. The solution has been playing a key role in supporting the FX market, growing from USD 1.2 trillion in 2001 to USD 6.5 trillion in 2022 in daily transactions amounts.*

Let us take advantage of this milestone to reassess the benefits of CLS.

What is CLS?

CLS is an independent multi-currency settlement system for FX transactions. Able to manage 18 currencies, it handles an average of one million daily transactions worth over USD 6.5 trillion (source: CLS, H1 2022 figures).

“Over 70 of the world’s most important financial institutions choose to be direct members of CLS, and over 30,000 more market participants benefit from the use of our services. As we celebrate our 20th anniversary, we reflect on why these clients place their trust in us every day and what we deliver to them in return – now and in the future,” said Marc Bayle de Jessé, CLS CEO, in the article celebrating the CLS 20 years of service.

CLS was originally created to mitigate settlement risk, i.e. the risk of default of one of the counterparties[1], as a FX transaction is composed of two non-simultaneous cash flows.

A good example is a USD/JPY transaction:

  • Outside CLS, the seller settles his JPY on T-1, whilst the buyer settles the USD on T.
  • With CLS, the two flows are simultaneously settled. This is the Payment versus Payment (PvP) principle.

The primary advantage of CLS: reducing risk

International banks have been the first to adopt the CLS system in order to reduce their FX settlement risk, also called “Herstatt risk”. For a bit of history, in 1974, the bankruptcy of the German bank Herstatt blocked the dollar interbank payment system. Herstatt’s American counterparties found themselves with unsecured claims due to the time difference of their unsettled transactions with their German counterparts. Nowadays, this type of issue is something that would not happen to CLS users.

In recent history, we can mention the COVID-19 crisis that brought high volatility and short-term uncertainty over the FX markets in 2020. In this complex environment, CLS allowed participants to endure their peak of activity while facing controlled risk.

Automatically managing record volumes of transactions

In 2022, the daily trade volumes continued to increase:

  • H1 2022 saw an increase of 3% vs. H1 2021 (source: CLS 2022)

In parallel to the volumes, the CLS community has also been growing at a fast pace:

  • CLS participation increased from around 25,000 users mid-2020 to 30,000 two years later.

Optimising funding needs from forex transactions

Financial markets crisis, regardless of their origin, always lead to strong pressure on liquidity from investors and financial intermediaries.

Thanks to its process of offsetting flows by currency and value date, CLS helped to considerably reduce participants’ funding needs by more than 95% during the COVID-19 crisis (source: CLS, April 2020).

Moving towards a broader adoption of CLS?

Since 2020, market conditions have been putting CLS benefits to the test, even for participants with relatively limited FX volumes.

Institutional investors can use CLS to different ends. An asset manager can use CLS to optimise and simplify the operational processes of its forex transactions. An insurer, a pension fund or a sovereign wealth fund may be driven by the goal of making their FX transactions and assets more secure. A corporation may settle its FX trades in CLS to streamline FX post-trade processes.

Even international authorities – such as the central banks of the currencies covered by CLS or the Basel Committee on Banking Supervision (BCBS) – have long recognised the fundamental role of CLS in ensuring the stability and economic security of FX settlements between financial institutions.

However, CLS does not cover all FX transactions. Some participants are constrained by the 18-currency scope. Others deal in more complex transactions than traditional derivatives or process same day transactions, which are not part of the CLS processing scope.

Our forward looking view for CLS

While Continuous Linked Settlement is a mature service seen as the industry gold standard for FX settlement, the service is still gaining traction with new participants joining the platform on a regular basis.

As of writing, the community is mostly made of investment funds and banks (97%). Whereas, the corporate segment is still to tap into the benefits of CLS, currently representing less than 0.3% of participants (as of December 2021). We expect the adoption of CLS by this segment to grow in upcoming years.

Outside of that growth factor, we expect the overall usage of CLS to grow in the pursuit of three key drivers:

  1. FX counterparty access:

Concerns over economic growth in an inflationary environment, geopolitical uncertainties and tighter monetary policies from central banks have all increased the FX market volatility, leading financial institutions to be more conservative with their choice of counterparties.

“For many medium-sized banks or investment funds, the use of CLS enables a larger choice of counterparties.” says Julien Sabet, Business Development for Cash & Liquidity Management Solutions at BNP Paribas.

As such, many smaller FX players are looking to join CLS via an access provider in order to become eligible counterparties.

  1. End-to-end digitalisation:

Technology is also playing a key role in the quest to improve post-trade efficiency, where a fully automated process from execution to settlement is a real game changer.

Corporates, for whom the usage of electronic FX execution platforms has soared, are the perfect illustration of the search for fully automated solutions, directly in their Enterprise Resource Planning (ERP) of the FX activity.

  1. Cost and operational efficiency:

Maintaining cash accounts with multiple banks acting as FX counterparties can be costly and operationally cumbersome. Similarly, facing settlement fails as a result of non-received FX cash-flows can be costly and challenging. CLS is a solution to both instances above, which is why fund managers and corporates are looking at using CLS to manage their FX settlements.

CLS Bank Fact Sheet

  • Created in 2002
  • 18 currencies covered: Danish krone, Norwegian krone, Swedish krona, US dollar, Australian dollar, Canadian dollar, Hong Kong dollar, New Zealand dollar, Singapore dollar, euro, Swiss franc, British pound, Mexican peso, Hungarian forint, South African rand, Israeli shekel, South Korean won, yen
  • Eligible products:  FX spots, FX forwards and currency swaps
  • Systemically important market platform
  • Belongs to 71 settlement members, including BNP Paribas
  • Regulated by the US Federal Reserve

*Source: CLS, H1 2022

[1]It means that the Party A has paid for the currency sold, but never received the currency bought from Party B