CLS Bank aims to reduce settlement risk in foreign exchange transactions by providing payment-versus-payment settlement through a continuous linked settlement process. It will operate as a multi-currency bank to simultaneously settle both sides of FX transactions, eliminating Herstatt risk. CLS Bank will have direct settlement members and also allow access for user members and third party customers. Transactions will be settled through a three stage process of members paying net amounts owed, transactions being settled from a queue if risk controls are passed, and payments being made, with settlement being final and irrevocable. CLS Bank is expected to begin operating in mid-2000 and initially settle the major currencies representing about 80% of global FX volume.

1. FEDERAL RESERVE BANK
OF CHICAGO
CAPITAL MARKETS NEWS
March 1999

2. CLS Bank: A Long Desired Solution to Herstatt Risk
Background
E
ver since the failure of Bankhaus
Herstatt, 1 central bankers, regula­
tors, and foreign exchange market
participants have become increasingly
aware of the issues surrounding
settlement risk2 in foreign exchange trans­
actions. Given the estimated $1.25
trillion which traffics daily in the foreign
exchange marketplace, substantial efforts
have been directed towards the develop­
ment of a comprehensive framework
designed to mitigate the systemic risk
inherent in foreign exchange settlement.3
To that end, G-10 central banks have chal­
lenged the industry to develop multicur­
rency services that would augment the risk
reduction efforts of individual banks.
Prominent among these initiatives is the
work of a group of 20 major global banks
in forming a United Kingdom (UK) incor­
porated company, CLS Services Ltd.
("CLSS"), which has been instrumental in
the development of a "continuo�s linked
settlement" bank ("CLS Bank") to settle
foreign exchange deals.
Post-Herstatt, the industry has struggled
with a way to bring the finality and irrevo­
cability of the payment versus payment
methodology ("PvP") achieved on
RTGS 4 payments systems to foreign
exchange transactions. At the heart of the
CLS Bank concept is the creation of a cen­
tral point or "turntable"5 where all foreign
exchange transactions will be matched,
resulting in the payment of both legs of a
foreign exchange transaction exchanged
simultaneously with final and irrevocable
settlement. It should be noted that CLS
Bank is not a guarantor of payment in the
same vein as a clearinghouse, but rather
will act to assure a member bank that its
currency will not be transferred to its
counterparty without the other payment
being in place. If a member defaults, the
counterparty will receive its original
principal.
CLS Bank was incorporated in the UK
in June 1997, and is owned by its share­
holders who are expected to become
settlement members. The bank will
most likely be organized as a private
sector multi-currency U.S. Edge Act
Corporation subject to regulation by the
Federal Reserve Bank of New York.
Slated for live operation by mid 2000, the
bank will provide a form ofPvP settlement
for gross and netted transactions in the
major eligible 6 CLS currencies. The
intended initial currencies7, though small
in number, represent about 80% of the
global volume; extension provisions are in
place to include as many currencies as pos­
sible. On December 17, 1997, with share­
holder approval from all involved parties,
CLSS acquired 100% of New York based
Multinet International Bank ("Multinet")8
and London based Exchange Clearing
House Limited ("ECHO")9, the domi­
nant and competing foreign exchange net­
ting and clearing services. The acquisition
of these two existing clearing houses acted
to both achieve critical mass and establish a
global infrastructure platform for CLS
Bank. CLSS will integrate Multinet and
ECHO under the name Netco.
Membership Structure
The membership structure, as depicted
in Figure 1, will allow direct access to CLS
Bank by its settlement members who will
be required to meet eligibility criteria
regarding capital, credit rating, the ability
to meet funding requirements, and opera­
tional capabilities. Other participants will
have access to the bank as user members
and third party customers. Settlement
members will be responsible for paying in
the net amounts for all transactions due to
Figure 1
settle across their accounts, whether the
transactions are their own, those of user
members, or third party customers. CLS
Bank will maintain aggregate settlement
accounts directly with central banks
for each participating currency, and
will hold no overnight balances.
Furthermore, these accounts will be man­
aged so that no overnight or daylight over­
draft will be allowed. Linkages between
CLS Bank and the central banks will not be
used for transaction settlement, only to
move liquidity into and out of CLS Bank.
CLS Bank will maintain a single
account for each settlement member, with
sub-accounts in each currency. As noted,
members will not hold funds in their CLS
Bank accounts overnight. On an intra-day
basis each account opens with a zero bal­
ance and, by the end of the day, all settle­
ment proceeds will be paid out. Members
can hold short positions on individual cur­
rency sub-accounts (within risk control
limits) but will not be allowed to overdraw
their settlement account. The settlement
process consists of:
• matching linkedto transitions,
• processing them to a settlement queue,
• settling transactions, and
• posting payment to both members'
accounts only ifa transaction passes all
account level risk controls.
CLS
Bank
3
Third Party
Customer
Settlement
Member
User
Member
Settlement
Member
Third Party
Customer

3. CAPITAL MARKETS NEWS--------------------------------....!
CLS Bank: A Long Desired Solution to Herstatt Risk continued
Continuous Iinlred Settlement
When payment ispostedon the books of
CLS Bank, it is considered final and legally
irrevocable. Designed to occur on a fre­
quently repetitive cycle, the process pro­
duces "continuous linked settlement" for its
members, effectively eliminating exposure
to Herstatt risk. Throughout the process,
CLS Bank will match and clear transactions
acting as agent.
CLS Bank plans to offer continuous set­
tlement over a 5-hour time period. The
funding period will be set to make optimal
use of overlapping opening hours in the
three global time zones, thereby allowing
settlement members (and their nostro
banks) sufficient time to meet their funding
requirements. The intended operating day
for CLS Bank will be from 7:00 AM to
12:00 Noon Central European Time, cor­
responding to 3:00 P.M. to 8:00 PM in
Tokyo and1:00 A.M. to 6:00 A.M. in New
York. At the beginning of the day, partici­
pants will be advised of a payment schedule
reflecting the net amounts they must pay
and can expect to receive, based on the
assumption that all of the day's scheduled
transactions will, in fact, settle. Settlement
involves a 3-stage process, repeated every
few minutes over the 5-hour settlement
period:
Stage 1
When CLS Bank has calculated
members' net positions, it will send out pay­
in schedules, specifying the amounts due in
each short currency and the time by which
the funding must be paid. The net short
amount due in each currency must be paid
to CLS Bank by the settlement members via
their nostro agents who access local RTGS
payments systems.
Stage Z
Transactions are randomly placed in
queue. Transactions are settled only ifeach
ofthe two accounts involved in the transac­
tion passes three risk control tests:
• short position limits on individual
currencies,
• aggregate short position limits, and
• a net positive value test on the account.
If all tests pass, then the transaction can be
settled; otherwise, the transaction remains in
queue and will be tried again. CLS Bank
computer systems will settle as many trans­
actions as possible from the waiting queue
given the amount of liquidity in the system
at the time.
Stage 3
When the system determines that no
more transactions can be settled in that par­
ticular cycle, it initiates outgoing payments
via the local RTGS systems and settles trans­
actions on CLS Bank's books. The payment
is posted, it is simultaneous, and it is irrevo­
cable. The system repeats the three stage
process every few minutes, taking in pay­
ments as they arrive, settling transactions
from the queue, paying out, taking in new
payments and so on.
CLS' Role
An appropriate amount of intra-day liq­
uidity is required in order to facilitate the
"continuous settlement" process without
absorbing unnecessary liquidity from the
system. There willalways be a balancing act
between retaining versus returning liquidity,
which may differ by currency and the time
within the settlement day.11 As long as only
one member fails to make payment, CLS
Bank will have enough liquidity to guaran­
tee that other transactions settle. CLS Bank
will establish committed liquidity facilities
for each eligible currency from a diverse set
of providers. When a member misses a
required pay-in amount for any reason,
liquidity providers can be called upon to
supply the needed amount ofliquidity by
taking the long cash positions from a failing
member as collateral, while providing the
liquidity to settle the short positions. In the
event of multiple member failures, CLS
Bank will revise the paying schedule to
settle as many transactions as possible, so that
counterparties of the failing parties receive
payment in the expected currency. If a
transaction does not settle, settlement mem­
bers get their money back; although they
will have eliminated their settlement risk,
they will be exposed to replacement risk
and, possibly, market risk.
As noted, it is important to understand
that, unlike clearinghouse relationships,
4
CLS Bank does not become the counter­
party to the transactions. CLS Bank acts as
agent only, matching the transactions
between counterparties and settling them
when all matching criteria have been satis­
fied and all risk tests have been successfully
met. Additionally, the distinction between
transactions that remain in queue and those
that actually settle is important. If a settle­
ment member fails and cannot make its
obligations, its counterparty will not be
bailed out by a central fund. Rather, the
counterparty has the assurance that its own
payment will not be made and principal will
be returned or that CLS Bank will use its
liquidity resources, perform a swap, and
complete the transaction. CLS Bank will
settle trades on their settlement date; it does
not provide protection against the failure of
forward trades. If a member fails, all unset­
tled transactions with that member will be
removed from CLS Bank.
Future Outlook
CLSS is in bilateral discussions with cen­
tral banks in connection with currency eli­
gibility, and maintains ongoing dialogue
with G-10 central banks through the
Committee efPayment and Settlement Systems,
and the Subcommittee of Foreign Exchange
Settlement Risk. Although the basic overall
structure of CLS Bank has been deter­
mined, many ancillary details have not yet
been finalized. Meanwhile, industry critics
have expressed concerns on a number of
issues attendant to the process including
concentration risk, competitive advantage
for large banks, and problematicdistribution
of liquidity. Nevertheless, armed with the
commitment of the major foreign exchange
players, both market participants and regula­
tors seemingly welcome CLS Bank as a
major step in the implementation of a pri­
vate sectormulticurrency service solution to
foreign exchange settlement risk.
- Gloria Ikosi and Donna M. Zagorski
Bibliography
An Introduction to Continuous Linked Settlement,
CLS Services, September 1998.
David L. Roscoe III, "Continuous Linked
Settlement." In: Payments Systems in the Global
Economy: Risksand Opportunities. Proceedingsoftire
34th

4. Annual Conference on Bank Structure and Competition,
Federal Reserve Bank of Chicago, May 1998.
David Shirreff, "Plotting tlze Death cif Settleme11t
Risk", Euromoney, London, May 1998.
Acknowledgement
Theodore Lubke of the Federal Reserve Bank
of New York has been very generous with his time,
information on CLS Bank, and clarifications on
aspects of the risk management plan. We are grate­
ful for his input.
1Bankhaus Herstatt, a small bank in Cologne,
Germany, failed in 1974. Regulators closed its
doors during the banking day but after the close of
the interbank payments system in Germany. As a
result, foreign exchange counterparties who had
sent their German payments against anticipated
receipts of US dollars were left exposed to the full
value of the Deutsche mark deliveries made. This
intra-day settlement risk has come to be known as
"Herstatt risk".
2Foreign exchange settlement risk is the risk
that one party to a foreign exchange trade will pay
out the currency it has sold but not receive the cur­
rency it has bought (because of default by the party
from whom it is buying the currency.)
3 Settlement Risk in Foreign Exchange Transactions
("Allsopp Report"), prepared by the Committee on
Payment and Settlement Systems ("CPSS") of the
G-10 central banks, Bank for International
Settlements, Basie, Switzerland, March 1996.
4Real-time gross settlement systems ("RTGS"),
for large-value funds transfers, effect final settlement
of interbank funds transfers on a continuous
transaction-by-transaction basis throughout the
processing day.
5 David Shirreff, "Plotting the Death of
Settlement Risk", Euromoney, London, May 1998.
6Eligibility criteria include recognized right of
offset under the bankruptcy law in the currency's
homejurisdictionand alsoaccess to RTGS payment
systems.
7USD (United States), CAD (Canada), GBP
(United Kingdom), JPY Gapan), Euro (Euroland),
CHF (Switzerland).
8 Multinet was authorized in December 1996 as
a limited-purpose bank based in New York. There
was limited live testing of multilateral netting oper­
ations in December 1997, but full operation was
deferred while the merger talks (with CLSS) were
taking place.
9 ECHO (Exchange Clearing House Limited)
is a London-based clearing house for the multilat­
eral netting and settlement of spot and forward
foreign exchange obligations between its users.
ECHO began operations in 1995.
10A linked transaction may link gross trades, or
netted positions from bilateral and multilateral
netting services.
11 The settlement process is expected to operate
more efficiently if transactions are split into smaller
parts before they are added to the transaction queue.
Gross transactions will be split into smaller parts
before settlement starts and at predetermined levels;
netted transactions will be split at the time of the
settlement for 'maximum partial settlement'. CLS
Bank plans to return liquidity (make pay-outs) as
rapidly as possible during the day and will require
pay-ins on a gradual basis throughout the operation
cycle. Simulation analyses have indicated that 90%
of the transactions in the system will be settled
within minutes of the opening; within two hours of
the system close, 100% of the transactions will
be settled.
5

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OF CHICAGO
P. O . BOX 834
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Publisher
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Director, Capital Markets
Editors
Joe Cilia (312) 322-2368
Senior Capital Markets Anal
yst
Craig West (312) 322-2312
Senior Capital Markets Anal
yst
Capital Markets Group of
Supervision and Regulation
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