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Settlement: CLS passes the Refco test

Regulators can congratulate themselves after continuous linked settlement worked, but mutterings of serious shortcomings carry on.

Foreign exchange market participants should be relieved that the continuous linked settlement (CLS) system did exactly what it was designed to do as the US broker Refco collapsed into Chapter 11 bankruptcy in October. There are no reports of money being paid away without the opposite side of the transaction being received, which can be largely attributed to the success of CLS’s design.

Refco’s spectacular collapse will have revived memories of Baring Brothers’ demise in 1995 and, for those with really long memories, the failure of Bankhaus Herstatt in 1974. On that occasion, when German regulators closed down Herstatt, the bank had received its Deutschmark side of FX transactions in Europe before it had made any of its dollar payments in the US. The result was that counterparties were left holding unsecured claims against the insolvent bank’s assets.

Settlement risk, or Herstatt risk as it is often termed, has been a cause for concern ever since. The unregulated FX market was of particular concern, especially as it grew in size through the 1990s. Systemic risk as the result of a massive settlement failure was regarded as a major worry; the response was the creation and implementation of CLS.

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