Continuous Linked Settlement (CLS)

What is the primary function of the CLS system?

The primary function of the CLS system is to mitigate settlement risk, specifically 'Herstatt risk'—the risk that one party delivers the currency it sold but does not receive the currency it bought, typically due to a counterparty failure in a different time zone. CLS achieves this through Payment-versus-Payment (PvP) settlement, ensuring that the final transfer of one currency occurs simultaneously with the final transfer of the other. Launched in 2002, CLS processes approximately $6 trillion daily, settling 18 major currencies during a brief 5-hour window when all relevant Real-Time Gross Settlement (RTGS) systems are operational.

How does CLS reduce liquidity requirements for banks?

CLS significantly reduces the liquidity requirements for participating banks by employing multilateral netting. Instead of requiring banks to fund the gross value of every individual trade, CLS calculates the net obligations for each currency across all participants. This netting process dramatically lowers the actual settlement obligations, reducing the required liquidity by over 96%. This efficiency allows banks to manage their capital more effectively while maintaining high settlement security. However, only about 40% of all FX trades currently utilize CLS, meaning substantial settlement risk remains outside the system.

What is Herstatt risk and why did CLS need to be created?

Herstatt risk, also known as principal risk, is the risk of loss on an FX trade due to the failure of a counterparty after the first leg of the transaction has been paid but before the second leg is received. This risk was tragically highlighted by the 1974 failure of Herstatt Bank, which was closed by German regulators after receiving its Deutsche Mark payments but before the corresponding USD payments could be made due to time zone differences. This event exposed the systemic danger of cross-border settlement. CLS was developed over decades following this failure to introduce a standardized, simultaneous PvP mechanism to prevent such losses from cascading through the global financial system.

What is the standard settlement cycle for FX spot trades?

The standard settlement cycle for most FX spot trades is T+2, meaning settlement occurs two business days after the trade date. An exception is USD/CAD, which typically settles T+1. While CLS facilitates the final, simultaneous exchange of principal amounts, the underlying trades are executed in the interbank market on T+0. The two-day window allows time for administrative processes, compliance checks, and the necessary funding and netting calculations to be completed before the final settlement occurs through the CLS or corresponding RTGS systems.