Global Policy Forum

By Carolyn Cohn

The first global foreign exchange settlement bank, designed to guard against payments crises, started trading on Monday one year after the September 11 attacks posed a threat to financial systems. CLS (Continuous Linked Settlement), which has been five years in the making, provides a live link between central bank payment systems in the world's main financial centres, reducing the chance of a gridlock in the $1.2 trillion daily foreign exchange market.

Prompt action by the U.S. Federal Reserve prevented a payments breakdown a year ago, after several firms were affected by the attacks on the World Trade Center in New York. But the attacks highlighted concerns about the timelag between carrying out and settling currency deals. "The benefits in the reduction of global foreign exchange risk and (of) the commercial costs could not be more timely," said Joseph De Feo, chief executive of CLS.

CLS, a private sector initiative, was set up in response to pressure from central banks to remove so-called Herstatt risk, named after the failure of German bank I.D. Herstatt in 1974. The chain reaction of unpaid deals after the bank shut down disrupted the U.S. payment system for days. CLS is backed by 66 of the world's largest banks but was beset in early stages by technical and management problems. Only 39 of the banks are ready to start using the system this week, but CLS says the service will expand to include 12 more of its shareholder, or settlement, banks, and customer banks of settlement banks by the end of the year. CLS has retained bank support because banks feared the alternative would be an increase in the amount of capital they would need to set aside to cover settlement risk.

Payment systems are the plumbing that keeps money flowing through financial markets and their importance only becomes evident when they are disrupted. Foreign exchange deals pose a unique risk to national payment systems because their settlement takes at least two working days due to time zone differences. During this time banks are at risk because they pay out one currency they sold, for example yen, before they receive the currency, for example dollars, they bought. In many cases banks' exposure to a single party exceeds their entire capital.

CLS is the first centralised, global system designed to tackle this risk. Instead of two days to settle currency transactions, there will be a five-hour window, between 0700 and 1200 Central European Time (currently 0500-1000 GMT), for each side of the trade to be settled simultaneously.

CLS is based in New York but operates out of London. It will start operating in seven currencies: U.S. dollars, euros, yen, sterling, Swiss francs, Canadian and Australian dollars, and has approval from all the relevant central banks. Three more currencies -- the Swedish, Danish and Norwegian crowns -- are likely to come onstream in 2003, and the Singapore dollar, Hong Kong and New Zealand dollars in 2004, De Feo said. Further currencies are under discussion, he added.

Banks paid around $5 million to become CLS shareholders, but that price will rise. "People who buy shares now will find they are more expensive -- it will be more than $5 million. The original shareholders took on the start-up risk," said De Feo. Internal costs in linking to the system could also be $5 million, industry participants said. Settlement members will also have to pay to use the system, and that price should be around 1.00 sterling ($1.57) per transaction in two to three years' time, De Feo said.

But initially transaction fees will be higher, with a discount for large volume. "The transaction costs need to create sufficient revenue to operate the set-up," said De Feo. "But there will be no discount for large volume in the long run. We have a privileged position in terms of access to the central banks, and the quid pro quo is that we are highly regulated. We have to have an open access policy, and fairness of participation." Existing settlement members account for around 80 percent of the foreign exchange market in volume terms.

In addition to pleasing the regulators and so fending off the threat of higher capital costs, settlement members will from November be able to offer CLS services to their client banks, providing a further potential source of revenue.

FAIR USE NOTICE: This page contains copyrighted material the use of which has not been specifically authorized by the copyright owner. Global Policy Forum distributes this material without profit to those who have expressed a prior interest in receiving the included information for research and educational purposes. We believe this constitutes a fair use of any such copyrighted material as provided for in 17 U.S.C § 107. If you wish to use copyrighted material from this site for purposes of your own that go beyond fair use, you must obtain permission from the copyright owner.