Continuous linked settlement at last
The imminent implementation of T+0 settlement for foreign exchange ought in theory to be an all-round blessing for market participants, reducing Herstatt risk. Some banks will, however, fall outside the system, raising the possibility of a two-tier market with differential spreads. Members will also incur new risks.
Almost exactly five years after it was first announced, and after numerous delays, continuous linked settlement (CLS) is on the verge of becoming a reality. And with the backing of central banks in the G7 countries, plus 70 shareholder banks, everyone involved in the foreign exchange markets should sit up and take notice. Forex is the largest market in the world, with an estimated daily volume of about $2 trillion. Trades usually settle in T+2 or T+3, which means that at any one time the settlement risk on banks' books worldwide amounts to at least $4 trillion, millions of which go astray each day.
Ever since the collapse of German bank Herstatt in 1974, banks have been aware of this risk. But taking less risk would tend to reduce an institution's earning potential, which is why banks preferred to live with Herstatt risk for 23 years before agreeing together to reduce it.
CLS is a settlement service that will facilitate T+0 in the forex markets. It was born of pressure put on market players by central banks to reduce settlement risk. Recommendations were made in a 1996 BIS report, known as the Allsopp report.