Business

Effective system to manage risk

At the initiative of central banks of G-10 countries, a group of 20 banks set up a separate institution called CLS Services Ltd. in London in 1997 which has worked out a system of settlement of cross currency transactions that would eliminate settlement risks, says M. R. Ramesh.

SETTLEMENT OF a foreign exchange trade transaction requires payment of one currency and receipt of another currency. For example, if A sells U.S. dollars to B against Indian rupees, A has to get rupees and B has to get dollars. The rupees will be paid into A's account with a bank in India and the dollars in B's account with a bank in the U.S. In view of the time difference of about 10 hours between the two countries the rupees will be received by A well before the dollars are received by B and B is exposed to the principal risk of not getting the dollars after paying the rupees. This risk, called the Settlement Risk, is well documented in the case of Bankhans Herstatt (BH).

Bankhans Herstatt (BH) was a small bank in Cologne (Germany) quite active in the forex trade. On June 26,1974, the German Banking Supervisory Authority (GBSA) terminated the banking licence of BH and ordered liquidation during the day but after closure of banking hours in Germany at 3.30 p.m. Frankfurt time. In respect of the interbank payments due for settlement that day, counterparties to BH had irrevocably paid deutschmarks (DM) either through their branches or correspondents against the anticipated receipt of dollars from BH later in the day at New York after business opened there. Upon getting the information of termination of the banking licence at Frankfurt at 3.30 p.m. (New York time 10.30 a.m.) the New York correspondent of BH suspended all outgoing dollar payments of BH thus exposing the counterparties to full credit risk.

This type of risk in settlement of cross currency transactions came to be known as the Herstatt Risk after the above case. Since then central banks of the G-10 countries have been seriously engaged in finding a lasting solution to mitigate the settlement risk in cross border transactions, where volumes have been going up substantially and now stand at $2 trillion per day. At the initiative of these central banks, a group of 20 banks set up a separate institution called CLS Services Ltd. in London in 1997 which has worked out a system of settlement of cross currency transactions that would eliminate settlement risks. The CLS Bank, headquartered in New York, will be operating the CLS system of settlement of cross currencies.

The CLS system

CLS (continuous linked settlement) is a real time system that enables simultaneous settlement (of currencies) globally irrespective of time zones. CLS Bank is a multicurrency bank and the settlement members hold multicurrency accounts with the bank in which the settlement takes place. CLS Bank also holds accounts with the central banks of all participating currencies in the system. Since the settlements are done in the accounts with the central banks of the currencies concerned, they are final and irrevocable.

Payment v payment basis

CLS Bank commenced operations on September 9,2002 with seven currencies, namely, the U.S. dollar, Japanese yen, British pound, Euro, Swiss franc, Australian and Canadian dollars. Subsequently four currencies — the Danish krone, Norwegian krone, Singapore dollar and Swedish krone were added as CLS currencies. CLS Bank simultaneously settles the two legs of the foreign exchange transactions on a payment versus payment basis. This occurs in a five hour window (7 a.m. to 12 noon Central European Time) when the Real Time Gross Settlement (RTGS) system of different currencies is also open. While the settlement of each transaction submitted by the settlement banks is on gross basis in CLS books, payments are on net basis with net funds exchanged per currency; and these funds are paid/received via the RTGS. While the settlement members (about 70 in number) can settle the transactions directly through CLS Bank, others can become third party members to the settlement member and avail the services of CLS Bank. CLS has more than 100 third party members and on an average more than 100,000 transactions are settled daily.

Major benefits

Major benefits to the participants in CLS include elimination of principal credit risk, reduction in liquidity requirements and enhanced efficiency in operation. For its members, the Clearing Corporation of India Ltd. (CCIL) has come out with a proposal to extend the benefit of CLS for settlement of their cross currency deals. CCIL will become a third party to a settlement bank in CLS and CCIL members will be taken as fourth parties. CCIL will function only as an aggregator and the fourth party members will enjoy all the benefits available to third parties.

In addition, because of aggregation, CCIL is able to get more competitive commercial terms for CLS participation which otherwise these entities with their low volumes may not be able to manage. It is currently settling spot and forward forex transactions in U.S. dollars and rupees. With the proposals for settlement of cash and Tom ???? deals (in dollars /rupees) and also cross currencies through CLS Bank, CCIL will become a one-stop shop for settlement of all foreign exchange transactions of authorised dealers in India.

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