Question

A major initiative to reduce the settlement risk associated with payments arising from foreign exchange settlements is continuous linked settlement (CLS). Describe how CLS works to reduce settlement risk.

Answer 1

To answer this question, we first need to understand about the CLS.

CLS: Continuous Linked Settlement: It is a global system designed to mitigate the risk of settlement of foreign exchange transactions. CLS is established to avoid the risk of default of one or other party while speeding up of the process. Number of banks has been linked to create CLS and to make it easier and also to mitigate the settlement risk.

How CLS(Continuous linked Settlement) works:

• It is owned by 69 financial institutions which are important players in the foreign exchange market.
• CLS is designed to to settle large number of trades between number of parties and also focusing on the complex risk management mechanisms.
• It uses PVP(you get paid only if you pay) method to remove the principal risk from the FX settlement. On the day of settlement each counter party to the trades pays the currency it is selling, acting as a third party CLS mitigates the risk of settlement.

Below is the diagram which shows the process of settlement happens between counterparties and how CLS acts:

hence, above uploaded image clearly describes how CLS works to mitigate the Foreign Exchange Risk.