Although the forex market is decentralised and has no central exchange or clearing facility, firms that chose to use CLS to settle their FX transactions can mitigate the settlement risk associated with their trades.
[1] CLS achieve this thanks to a central net (bilateral and multilateral clearing) and gross payment versus payment settlement service directly connected to the real-time gross settlement systems of participating jurisdictions through accounts at each of their respective central banks.
[4] The creation of CLS was a delayed collective response to the turmoil that followed the failure of Germany's Herstatt Bank on 26 June 1974, which highlighted the counterparty risk inherent in the system of multilateral net settlement through which forex transactions were executed at the time.
[5]: 55 The core challenge resulted from the practice of settling each leg of a forex transaction independently, and often at different times with a lag, in the country of issue of each currency.
[6]: 38 A series of reports by these groups paved the way towards the creation of CLS, each named after the official who chaired the committee that prepared it:[6]: 38-44 Such initiatives also initially included FXNet, which netted trades each day by counterparty pair; the Exchange Clearing HOuse Ltd (ECHO), a London-based multilateral netting system which started operations in August 1995;[5]: 59 [6]: 56 and Multinet International Bank, a New York State-chartered bank that similarly developed a multilateral forex netting clearing house.
[6]: 47 Pressure from the central banks, including the publication of the Allsopp report in 1996, led the G20 to meet regularly and focus on a common solution to reduce foreign-exchange-related credit risk.
[5]: 60 By the spring of 1997, the G20 banks determined that the future system should rely on a central bank account and membership in the respective real-time gross settlement system in each jurisdiction (known in the payments jargon as a nostro relationship), but no physical presence other than in the United States, United Kingdom, and Japan in order to save costs.
[6]: 61 This required ad hoc legislation to be passed in participating countries, and also the extension of operating hours in Australia, Canada and Japan.
[6]: 60 On 1 November 1999, CLS Bank International was established as a New York Edge Act financial institution after the Federal Reserve approved its application, which had been filed on 6 August 1999.
[6]: 65 Lawrence M. Sweet, an official at the Federal Reserve Bank of New York seconded at the BIS from 1994, was instrumental in the elaboration of the CLS concept as secretary, then chair of the CPSS Steering Group on Foreign Exchange Settlement Risk.
[17] CLS Group is a commercial entity that is operated on a not-for-profit basis, similarly as the Depository Trust & Clearing Corporation.
CLS Bank is connected to the real-time gross settlement systems of participating jurisdictions and holds accounts at their respective central banks, typically enabled (outside of the United States) by ad hoc legislation that exempts CLS from local establishment requirements.
As such, CLS Bank is connected to Fedwire in the United States, T2 in the euro area, CHAPS in the United Kingdom, SIC in Switzerland, the Reserve Bank Information and Transfer System (RITS) through the SWIFT Payment Delivery Service in Australia, KRONOS in Denmark, CHATS in Hong Kong, BOJ-NET in Japan, BOK-Wire in South Korea, ESAS in New Zealand, Norges Bank Settlement System (NBO) in Norway, MEPS+ in Singapore, SAMOS in South Africa, RIX [sv] in Sweden, etc.
Another key element of the CLS Settlement Service is the liquidity efficiencies delivered through multilateral payment netting.
One of the “legs” is settled inside CLS in order to reduce each settlement member’s net position in the two relevant currencies.
The in/out swap further compresses payment obligation by an average of 75%, which results in a funding requirement in CLS of less than 1% of the total gross settlement value.