CLS (originally Continuous Linked Settlement) is a specialist US financial institution that provides settlement services to its members in the foreign exchange market (FX). Although the forex market is decentralised and has no central exchange or clearing facility, firms that chose to use CLS to settle their FX transactions can mitigate the settlement risk associated with their trades.
CLS does this through the operation of a payment versus payment (PvP) settlement service which mitigates settlement risk for the FX transactions of its settlement members and their customers (third parties).
The service started operating in 2002 as an Edge Act Corporation, a limited purpose bank regulated by the Federal Reserve Bank of New York.
Since it began operations in 2002, CLS has rapidly increased and by March 2017 was settling just over 50% of global FX transactions. As a result, the Financial Stability Oversight Council (FSOC) officially designated CLS a systemically important financial market utility in July 2012.
The single day record for value settled is US$11.11 trillion, set on 21 June 2017. The single day record for volume settled is 2.58 million, set on 14 November 2016.
In 2002, CLS was launched with 39 members and seven currencies. As of September 2017, CLS settles 18 currencies, has 79 shareholders, 66 settlement members and 24,000+ third-party clients.
CLS operates a global multi-currency cash settlement system through which settlement risk can be mitigated with finality using a combination of PvP settlement over CLS central bank accounts, local real-time gross settlements systems (RTGS) and multilateral payment netting supported by a resilient infrastructure.
In a PvP system both sides’ payment instructions for a FX transaction are settled simultaneously. Without PvP there is a serious risk that one party to a FX transaction will deliver the currency it owes, but not receive the other currency from its counterparty, resulting in the loss of principal. This is known as settlement risk, or “Herstatt Risk”, after the German bank, Bankhaus Herstatt, which collapsed in June 1974 leaving many of its FX counterparties with significant losses. In 1995 the Bank for International Settlements presented a possible solution on a PvP basis. In an advancement to this proposal the G20 banks founded an earmarked financial institute, the CLS Bank International.
How it works
Following an FX transaction, settlement members submit payment instructions to CLS. These instructions are authenticated and matched by CLS and maintained by the system until settlement date. The CLS daily settlement cycle operates with settlement and funding occurring during a five-hour window when all real-time gross settlement (RTGS) systems in the CLS settlement currency jurisdictions are open and able to make and receive payments. This enables simultaneous settlement of the payments on both sides of an FX transaction.
Each settlement member holds a single multi-currency account with CLS. At the start and end of a normal settlement day, each settlement member has a zero balance on its account. Under normal operations of the settlement service, CLS starts and ends the day with a zero balance in its central bank accounts and in its Settlement Member accounts. Settlement members may submit instructions relating to their own FX transactions as well as the FX transactions of their third-party customers directly to CLS.
CLS holds accounts with each of the central banks whose currencies it settles.
On each settlement date, upon determining that the accounts of the submitting settlement members satisfy several risk management tests, CLS simultaneously settles each pair of matched payment instructions by making the corresponding debit and credit entries in the settlement members’ accounts at CLS. The settlement of the payment instructions and the associated payments are final and irrevocable.
For example, (GBP/USD = 1.50, EUR/USD = 1.25):
- By trades:
- Member 1: Buys 1,000 GBP/USD from Member 2
- Member 2: Buys 1,000 EUR/USD from Member 3
- Member 3: Buys 1,000 GBP/USD from Member 1
- By currency positions:
- Member 1: Owes USD1500 and GBP1000, collects USD1500 and GBP1000
- Member 2: Owes USD1250 and GBP1000, collects EUR1000 and USD1500
- Member 3: Owes USD1500 and EUR1000, collects USD1250 and GBP1000
- CLS then multi-laterally nets the total obligations:
- Member 1: Pays 0.0 and receives 0.0
- Member 2: Pays GBP1000, and receives EUR1000 and USD250
- Member 3: Pays USD250 and EUR1000, and receives GBP1000
These obligations are funded into and from each member’s respective multi-currency account.
Another key element of the CLS Settlement Service is the liquidity efficiencies delivered through multilateral payment netting. On each day participants will very likely have more than one trade to settle—in practice, major banks will have hundreds or thousands of trades each day. Each day prior to settlement, CLS calculates the funding required of each settlement member on a multilateral netted basis. The amount of cash required by CLS to settle all payment instructions is reduced, allowing each settlement member to transfer only the net amount of its payment obligations in each currency, rather than the total amount of each trade to be settled. On average, CLS netting efficiency is in the region of 96 percent.
In addition to the usual settlement service, the in/out swap process  is done before the settlement windows to reduce the payment obligations to CLS and to mitigate liquidity pressures. An in/out swap is an intraday swap consisting of two equal and opposite FX transactions that are agreed as an intraday swap.
One of the “legs” is settled inside CLS in order to reduce each settlement member’s net position in the two relevant currencies. The other “leg” is settled outside CLS.
The in/out swap further compresses payment obligation by an average of 75%, which results in a funding requirement in CLS of less than 1% of the total gross settlement value.
CLS has expanded the number of currencies it settles over the years and currently settles:
|Hong Kong||HKD||Hong Kong dollar|
|Israel||ILS||Israeli new shekel|
|New Zealand||NZD||New Zealand dollar|
|South Africa||ZAR||South African rand|
|South Korea||KRW||South Korean won|
|United Kingdom||GBP||Pound sterling|
|United States||USD||United States dollar|
- ^“BIS report” (PDF). BIS.org. Retrieved 2012-07-01.
- ^“About CLS”. Cls-group.com. Retrieved 2012-06-30.
- ^“Daily FX trade more like $3 trillion than 5 -CLS”. CNBC. Retrieved 2017-03-13.
- ^“Financial Stability Oversight Council Makes First Designations in Effort to Protect Against Future Financial Crises”. treasury.gov. Retrieved 2012-10-18.
- ^“CLS Settlement”. Cls-group.com. Retrieved 2012-06-30.
- ^“Bank Failures in Mature Economies”. Bis.org. Retrieved 2012-06-30.
- ^Bank for International Settlements, Payment systems in countries of the Group of Ten, 1995, page 551
- ^Bank for International Settlements, Quarterly report December 2002, page 69.
- ^“CLS Bank & the World of FX Settlement”. Forex Magnates. Retrieved 2014-06-14.
- ^“In/Out Swaps”. CLS. Retrieved 2014-06-14.
Ofer Abarbanel is a 25 year securities lending broker and expert who has advised many Israeli regulators, among them the Israel Tax Authority, with respect to stock loans, repurchase agreements and credit derivatives. Founder of TBIL.co STATX Fund.