Create account Login Subscribe. Why foreign exchange transactions did not freeze up during the global financial crisis: The role of the CLS Bank.

Richard Levich 10 July How can markets prevent counterparty failure from cascading into broad financial turmoil? Administration officials have once again put the need for new trading systems for complex derivatives on the front burner. Officials are right to be concerned, as many new financial products represent contracts between two counterparties — banks, brokerage houses, insurance companies, and hedge funds, among others — without the benefit of a centralised exchange or clearinghouse.

But there is a follow on impact on C and D who trade bilaterally with B and on E and F who trade bilaterally with C and D , and so on. It is well known that organised futures and option markets utilise a well-capitalised central clearinghouse and a mark-to-market convention that imposes a daily discipline on traders and prevents credit events at firm A from cascading onto firms B, C and D.

Far less well known is how the historic practice of bilateral trading and bilateral clearing and settlement posed a huge risk for another giant international financial market — the foreign exchange market — and how a new private institution the CLS Bank developed to counteract these risks and protect the foreign exchange market even in the face of a global financial crisis like the one we are now experiencing.

The story is instructive in revealing not only how critical the new institution is to the steady operation of the foreign exchange FX market but also how long the process of developing something comparable for complex derivatives might take. It is easy to appreciate that FX trading involves many risks. But credit risk can be a far more serious, and even fatal, blow to a trading bank. And surprising as it may seem, this risk is in large part due to time zone differences and the fact that every foreign exchange transaction has two legs that occur in different countries.

Suppose a US bank Yankee Bank enters into an FX trade with a Japanese bank Samurai Bank. This delivery takes place during Tokyo business hours, say 10 a.

This scenario might seem dire and improbable. But it actually has happened in the foreign exchange market, and on more than one occasion, most famously in with Herstatt Bank, a privately owned bank based in Cologne, Germany.

On June 26, , counterparty banks around the world paid deutsche marks to Herstatt in Cologne expecting Herstatt to reciprocate and pay out US dollars during local banking hours in the United States. But Herstatt declared bankruptcy on June 26 and never fulfilled its leg of these FX transactions leaving numerous institutions e.

Morgan Guaranty Trust, Seattle First National, and Hill Samuel with losses of tens of millions of dollars each. First, in the s, banks relied on a multilateral clearing system. Each of the hundreds of banks trading foreign exchange potentially had counterparty transactions with hundreds of other banks, creating thousands of bilateral transactions.

One failed bank could impact dozens or hundreds of counterparties. And second, time zone differences meant that banks further along in the hour trading day were at risk from a bank failure occurring in an earlier time zone. Some solutions were proposed e. But the ultimate solution only arrived when a new institution, the CLS Bank , was developed in the s and launched in the fall of The innovation that solved the Herstatt risk problem is at once quite simple but also quite sophisticated.

Think of a scene from a movie where two distrustful characters enter into a bet, where a condition is that their wagers are held by a third party i. Delivery risk is thus removed because both counterparties have paid and released their funds to a reliable third party.

In foreign exchange, the CLS Bank uses a similar payment-versus-payment system whereby payments from Yankee Bank to Samurai Bank and vice-versa are paid to the CLS Bank, not bilaterally.

Only when both legs of the transaction are received does the CLS Bank make irrevocable payments to both counterparties. Another feature of the CLS system is multilateral netting, meaning that bilateral transactions across counterparties can be netted out to reduce the actual payments and funds used in the system.

Error (Forbidden)

To be effective at reducing Herstatt risk and not introducing any new risks, the credit standing and operating efficiency of the CLS Bank needs to be beyond reproach. The CLS Bank is a private institution, owned by a consortium of roughly 70 member banks from 22 countries.

The CLS Bank is based in New York and operates under Federal Reserve Bank regulation.

In addition to 60 settlement members, more than 4, other institutions participate in the system. Presently, the CLS Bank handles trades in 17 CLS-eligible currencies among CLS-eligible counterparties. On their peak day in September , in the midst of the global crisis, the CLS Bank handled more than 1.

In other words, near the peak of the freeze in interbank lending, the CLS Bank was handling a record volume of FX trades for thousands of counterparties — and all handled by a payment-versus-payment system, essentially free of Herstatt risk. In the fall of , the financial crisis that began in the United State intensified and took on global dimensions. Financial markets froze as a growing list of financial institutions failed e. Bear Stearns, IndyMac, Fannie Mae, Freddie Mac, Washington Mutual, Lehman Brothers, etc.

A rising crescendo of weak economic fundamentals spread fear about the quality and perhaps viability of many well-known financial players. Against this backdrop, the foreign exchange market stayed vibrant, and activity levels rose relative to prior years.

According to the semi-annual market survey prepared by the New York Foreign Exchange Committee, an industry group focused on business guidelines and best practices, overall FX trading volume in New York grew by 8. And spot FX transactions grew by a full That a market so huge and so central to global economic activity was able to withstand the financial crisis, and in fact expand trading volume, demonstrates how potent the CLS Bank was at mitigating counterparty risks in foreign exchange clearing and settlement.

If this concern over bank credit worthiness had spread to foreign exchange, it would have dealt a serious blow to global trade and real economic activity over and above the impact of the financial crisis itself.

Almost 35 years ago, the foreign exchange market experienced a shock that many years later led to the formation of a centralised, heavily capitalised clearing and settlement bank to handle transactions among a dispersed set of institutions trading in a multilateral marketplace.

The CLS Bank effectively diffused the massive credit and counterparty risk that would haunt a marketplace with thousands of trading counterparties who exchange sums in the trillions on a daily basis. With less risk in a CLS-enabled trade, banks need less capital to support interbank trading, providing a natural incentive to use the CLS system.

It took many years and a substantial investment to develop and implement the CLS Bank system. But the new institution clearly proved its worth by keeping the financial crisis from infecting global trade in goods and services that relies on a well-functioning foreign exchange market. Recently, the CLS Bank has partnered with the Depository Trust and Clearing Corporation to facilitate the processing and settlement of certain over-the-counter credit derivatives. This is a useful step forward.

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A complete solution — allowing market economies to retain the benefits of trading in new financial derivatives without being subject to system-threatening shocks if one counterparty in a transaction fails in its obligations — will take more time and money.

If only these investments had been made earlier. Japanese yen payments are cleared and settled through institutions in Japan, while US dollar payments are cleared and settled through institutions in the United States. If Samurai were to provide Yankee Bank with a USD check at 10 a. Tokyo time, the funds could not be confirmed as good funds until the United States banking system opened to process, collect and settle on the check.

The situation is somewhat analogous to anyone asked to accept an out-of-town check, not knowing if it will be good once presented for collection. Financial markets International finance. Professor of Finance and International Business and Deputy Chair of the Department of Finance at Leonard N.

Stern School of Business, New York University. Columns By Topic By Date By Reads By Tag Video Vox Vox Talks Publications ePubs CEPR Reports People A B C D E F G H I J K L M N O P Q R S T U V W X Y Z Debates Rebooting Europe Secular Stagnation What's the use of economics? The role of the CLS Bank Richard Levich 10 July How can markets prevent counterparty failure from cascading into broad financial turmoil?

Credit risk in foreign exchange transactions It is easy to appreciate that FX trading involves many risks.

How the CLS Bank mitigates delivery risk in the foreign exchange market The innovation that solved the Herstatt risk problem is at once quite simple but also quite sophisticated. Foreign exchange markets expended trading during the crisis In the fall of , the financial crisis that began in the United State intensified and took on global dimensions. Footnotes 1 Note the important role of the national bank clearing agents in the collection process.

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