The Foreign Exchange market in 2020: three benefits of Continuous Linked Settlement (CLS)

International financial markets – particularly the Foreign Exchange (forex or FX) markets, experienced a period of extreme volatility in 2020 triggered by the Covid 19 crisis. This was the ideal moment to assess the benefits that a market platform like Continuous Linked Settlement (CLS) could bring to international investors.

What does CLS do?

In short, CLS is a multi-currency settlement system for FX transactions. Able to manage 18 currencies, it handles on average one million transactions daily worth over USD3 trillion (source: CLS, 2020).

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

A good example is a USD/JPY transaction:

  • Outside CLS, the seller settles his YEN on T-1, whilst the buyer settles US dollars on T.
  • In CLS, the two flows are simultaneously settled. This is the Payment versus Payment, or PvP, principle.

The primary advantage of CLS: reducing risks

International banks have been the first to overwhelmingly adopt the CLS system in order to reduce their FX settlement risk, commonly called “Herstatt risk”. 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 counterpart.

In 2020, despite intense FX activity in the beginning of the year, CLS participants were able to continue following their forex transactions in real time and immediately detect any problems leading to interact with their counterparties.

In addition, the FX market volatility in early 2020 highlighted once again other CLS benefits such as operational efficiency and liquidity requirement optimisation. Both of these benefits can meet the specific needs expressed by institutional investors, e.g. such asset managers, insurers or pension funds.

Automatically managing record volumes of transactions

March 2020 was a record month of activity: volumes were up 25% compared to February 2020; 65% more Euro/Dollar transactions, and strong growth in spot FX transactions (source: CLS, 2020). Market operators, treasurers and asset managers faced a very high degree of short-term uncertainty in their activity, with rapid portfolio movements and sharply changing exchange rates.

The majority of financial institutions effectively managed this increase in transaction volumes fairly easily with operational teams working remotely due to local government lockdown policies.

In this environment, CLS’s 25,000 participants benefited from the high degree of automation of the CLS settlement processes, which reduced their operational burden.  These integrated settlement processes, which are the same regardless of the currency, enabled the sudden increase in volumes and transactions to be absorbed, allowing operational teams to manage their day-to-day business “almost as usual”.

Optimising funding needs from forex transactions

A financial markets crisis, regardless of its origin, always leads 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 crisis (source: CLS, April 2020).

Moving towards broader adoption of CLS?

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

2020 was a full-scale test of the benefits that CLS can bring, even to participants with relatively limited FX volumes. An asset manager can use CLS as a driver to optimise and simplify the operational processes of its forex transactions. An insurer, a pension fund or a sovereign wealth fund may be motivated with the goal of making their FX transactions and assets more secure.

Nonetheless, 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 CLS processing scope.

Along with BNP Paribas group, we have become a CLS’s leading service provider, as an agent for the Eurozone, with corporate clients as well as institutional investors and banks. BNP Paribas Securities Services teams have developed the expertise to support its custody clients in defining their needs, through all stages of the CLS implementation project.

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: spot FX, forward FX as well as currency swaps
  • Systemically important market platform
  • Belongs to 71 settlement members, including BNP Paribas SA
  • Regulated by the US Federal Reserve

It means that the Party A as paid for the currency sold, but never received the currency bought from Party B

This article is intended for professional and/or eligible counterparties, and not intended for retail clients.