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A continuous linked settlement is the process of settling foreign exchange transactions cooperatively among major banks to reduce the settlement risk. Since 2002, CLS Group Holdings, or CLS, an entity owned by some of the world's leading financial institutions, eliminates the settlement risk for transactions it processes through a payment-versus-payment mechanism that assures simultaneous payment of both currencies in an exchange transaction. All transactions processed under the system are netted, thereby resulting in a substantial reduction in the number of bank-to-bank payments and the cost of making the completed payments.
A foreign exchange transaction involves the payment of a currency by one party in exchange for the payment of a different currency by another party. If both payments do not happen at the same time, the risk arises that one party will complete the payment of a currency and the other party will fail to do so, such as might happen if one of the banks handling the transaction defaults before the transaction is completed. The continuous linked settlement system was developed to eliminate this risk. Given the huge volumes of currencies traded on a daily basis, foreign exchange failures could have a major impact on the international finance system.
The continuous linked settlement system operates from London where it can be most effective in responding to requirements from financial markets around the world. A settlement window of five hours is used to overlap operating times for these institutions. The settlement period begins at 7:00 a.m. Central European Time and ends at noon. CLS trades in 17 currencies and settles more than half of all foreign exchange transactions worldwide.
CLS maintains real time gross settlement (RTGS) accounts at participating central banks. Settlement members, i.e., shareholders of CLS, maintain multi-currency accounts at CLS. Members submit instructions for exchange transactions and CLS matches them and validates both sides of the exchange. Settlements are processed only for transactions in which members have adequate funds in the appropriate currency and sufficient liquidity to complete the payment. If one of the parties to the transaction lacks sufficient funds, the continuous linked settlement system holds that transaction until the next cycle when it will be checked again for funds availability.
Settlement members are notified of required payments due to be settled on a given day based on their net position of each currency. Transfers are not required for each transaction processed, but are made based on the total funds required for all validated and finalized payments within a liquidity minimum limit established by CLS. The continuous linked settlement system reduces the requirements on settlement members for collateral in RTGS accounts and balances maintained at the central banks, but it does require sufficient liquidity for processing of exchange transactions during the cycle.
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