9/4/2020 Central Banks Cooperate to reduce FX Risk | American Express

 Log In

FX International Payments

Log in | Support

Inquire

See application

International Payments  Foreign Exchange Articles For Businesses 

How Central Banks Cooperate to Reduce FX Risk in International Settlements

How Central Banks Cooperate

to Reduce FX Risk in
International Settlements
By Frances Coppola

Businesses that trade in multiple currencies are aware,

of course, that they face many FX risks. But the source
of certain FX risks is not always clear. In particular, the
source of settlement risk can be obscure. While the
world’s central banks are cooperating to try to eliminate
settlement risk, it’s a work in progress – so it’s still
important for financial decision makers to understand
https://www.americanexpress.com/us/foreign-exchange/articles/central-banks-cooperate-to-reduce-FX-risk/ 1/8
9/4/2020 Central Banks Cooperate to reduce FX Risk | American Express

 the mechanics behind settlement FX risk if they wish to Log In

minimize their exposure to it.

A forex contract is an agreement to exchange a quantity of one currency for a

quantity of another. The ratio of the quantities is the exchange rate. So, for
example, if a bank based in London enters into a forex contract to sell 100,000
pounds sterling and buy U.S. dollars at an exchange rate of 1.28, it will receive
$128,000. We would expect this exchange to be instantaneous. But in
practice, even with same-day settlement, the bank would not receive the
dollars immediately. This is because London is five hours ahead of New York,
where the U.S. leg of the contract would be processed. Thus, a trade done at
10 a.m. London time wouldn’t settle until New York trading begins two or three
hours later (depending on time of year). During the intervening period, the
bank incurs FX “settlement risk,” which is the risk that one leg of the contract
will fail to settle. The FX risk is that the bank might pay 100,000 pounds
sterling at 10 a.m. London time, but then fail to receive the $128,000 in return
when New York opens.

How Herstatt Bank’s Failure

Highlighted FX Risk In International
Payments
This sort of FX risk is known as “Herstatt risk,” after a German bank whose
failure in 1974 nearly caused meltdown of the international FX settlement
system. At 3:30 p.m. local time on June 26, 1974, German regulators closed
Bankhaus Herstatt. Normally, failure of a medium-sized European bank should
not cause major disruption to the global financial system. But Bankhaus
Herstatt was a major player in international forex. It acted as an intermediary
for bank-to-bank forex trading involving Deutschmarks and U.S. dollars. The
scale of its activities was far out of proportion to its size. Thus, when it failed, it
was unable to meet its FX obligations.

When the regulators closed Bankhaus Herstatt, banks that had already paid
deutschmarks and expected U.S. dollars to be delivered in New York found
themselves out of pocket. Bankhaus Herstatt had not remitted funds to its New
York correspondent banks, so the correspondent banks refused to deliver the
dollars. Fearing that they in turn would be left out of pocket, other banks
involved in the FX transactions halted outgoing payments for themselves and
their customers. The chain reaction propagated across New York’s payments
network. According to the Bank for International Settlements (BIS), the amount
of gross funds transferred by this network declined by an estimated 60 percent
in just three days.1

https://www.americanexpress.com/us/foreign-exchange/articles/central-banks-cooperate-to-reduce-FX-risk/ 2/8
9/4/2020 Central Banks Cooperate to reduce FX Risk | American Express

Herstatt Bank’s failure was one of the factors that led to the creation of central
 bank real-time gross settlement (RTGS) systems. The idea was that if
Log In

transactions could be settled in real time, the time zone problem at the heart of
the 1974 panic could be eliminated. Furthermore, since central banks can
create unlimited quantities of their own currencies, no transactions would fail
because of insolvency of an intermediary. So there is zero settlement risk in a
U.S. dollar payment sent via Fedwire, for example, or in a sterling payment
sent via CHAPs in the U.K.

Central Bank RTGS Systems Can’t

Completely Eliminate Currency Risk
However, the introduction of central bank RTGS systems did not completely
eliminate the FX risk highlighted by Bankhaus Herstatt’s failure. Central banks
only have limited amounts of foreign currencies. So, to ensure that neither leg
of the transaction could fail, two central bank RTGS systems needed to be
involved – one for each currency. But this meant that the two legs of the FX
deal would settle separately, each in their own time zone. There would be no
risk of default, but there would still be another type of FX risk: in cross-
currency transactions, settling the individual currencies in their own time zones
can cause severe cash flow problems for banks and businesses.

An example provided by BIS makes the point: “For example, delivery of dollars
to a bank in Japan by a U.S. bank in New York would occur during New York
business hours, while the corresponding delivery of yen by the Japanese bank
to its U.S. counterparty would occur during Tokyo business hours. The bank
delivering yen could have to wait up to 12 hours before receiving dollars.”2

To resolve this problem, a group of banks called the G20 developed the
Continuous Linked Settlement system (CLS), which would link together RTGS
settlement in all major currencies so that FX transactions could be seamlessly
done across time zones without incurring Herstatt risk.3

The CLS System – A Work In Progress

Since 2002, international FX settlement in major currencies has been
executed via the CLS system. Currently, CLS settles 18 currencies and more
are planned.4 CLS settles FX transactions in real time during a five-hour
window when all 18 central bank RTGS systems are simultaneously online:
the “legs” of FX transactions, including derivatives, are settled simultaneously.
Transactions submitted after that window are stored until the next day.5

CLS eliminates Herstatt FX risk. But it does so by severely restricting the times
during which FX transactions can be settled. This seemed a reasonable
compromise when FX settlement was typically two days after the trade date
https://www.americanexpress.com/us/foreign-exchange/articles/central-banks-cooperate-to-reduce-FX-risk/ 3/8
9/4/2020 Central Banks Cooperate to reduce FX Risk | American Express

and markets closed overnight. But now that trading activity continues day and
 night around the world, the five-hour CLS window appears too restrictive. A
Log In

survey conducted by BIS in 2008 recommended that CLS should be extended

to provide same-day settlement.6 In September 2013, CLS introduced same-
day settlement of FX transactions in U.S. and Canadian dollars, including
transactions submitted after the five-hour window.7 CLS says it is “actively
seeking to extend the coverage of its settlement risk mitigation service -
bringing in more participants, more currencies and providing more settlement
sessions.”8

Related Links

International Payments for Business

Business Payment Methods and Solutions

Frequently Asked Questions

Popular Articles

Strong Countermeasures Help Businesses Avoid International Wire Transfer

Fraud

The Impact of New Digital-Era Taxation on Global Supply Chain

Management

Electronic Invoicing: Paving the Way To Straight-Through Invoice

Processing And Global Business Services

The
Takeaway:

The CLS system has successfully eliminated Herstatt FX risk for major
currencies, and as more currencies join the system, the risk of losses in minor
i ill d t N th h ll i t t th
https://www.americanexpress.com/us/foreign-exchange/articles/central-banks-cooperate-to-reduce-FX-risk/
d fb k 4/8
9/4/2020 Central Banks Cooperate to reduce FX Risk | American Express
currencies will reduce too. Now, the challenge is to meet the needs of banks
and businesses around the world for fast, reliable and secure FX settlement.
 Log In

The Author
Frances Coppola

With 17 years’ experience in the financial industry, Frances is a highly regarded

writer and speaker on banking, finance and economics. She writes regularly for
the Financial Times, Forbes and a range of financial industry publications. Her
writing has featured in The Economist, the New York Times and the Wall Street
Journal. She is a frequent commentator on TV, radio and online news media
including the BBC and RT TV.

Sources

1. "Settlement risk in foreign exchange markets and CLS Bank", BIS; http://www.bis.org/publ/qtrpdf/r_qt0212f.pdf

2. "Settlement risk in foreign exchange markets and CLS Bank", BIS, ibid.

3. "Mitigating Risk and Enhancing Financial Stability in the Global FX Market", CLS Group;https://www.cls-

group.com/Publications/CLS Brochure DPS Web.pdf

4. Currencies, CLS Group; https://www.cls-group.com/About/Pages/Currencies.aspx

5. "How CLS works", CLS Group; https://www.cls-group.com/ProdServ/Settlement/Pages/How.aspx

6. "Progress in reducing foreign exchange settlement risk", BIS; http://www.bis.org/cpmi/publ/d83.pdf

7. "Same day settlement", CLS Group; https://www.cls-group.com/ProdServ/Pages/same-day-settlement.aspx

8. CLS Products & Services, CLS Group; https://www.cls-group.com/ProdServ/Pages/default.aspx

https://www.americanexpress.com/us/foreign-exchange/articles/central-banks-cooperate-to-reduce-FX-risk/ 5/8
9/4/2020 Central Banks Cooperate to reduce FX Risk | American Express

Related Articles
 Log In

Simple FX Risk Hedging for SMEs

Negative Rates, Part 1: Unexpected Ways Negative

Interest Rates Influence Currency Exchange Rates

https://www.americanexpress.com/us/foreign-exchange/articles/central-banks-cooperate-to-reduce-FX-risk/ 6/8
9/4/2020 Central Banks Cooperate to reduce FX Risk | American Express

 Log In

Forward Contracts and Forex Volatility

Make International Payments

Inquire

See Application

Existing FX International Payments customers log in here

Terms and Conditions



Article(s) on this website that are identified as being prepared by third parties
are made available to you for information purposes only. These third party
articles do not represent the opinions, views or analysis of
American Express and American Express does not make any
representations as to their accuracy or completeness. If you have questions
about the matters discussed in those articles, please consult your own legal,

 About

 Products & Services

 Links You May Like

https://www.americanexpress.com/us/foreign-exchange/articles/central-banks-cooperate-to-reduce-FX-risk/ 7/8
9/4/2020 Central Banks Cooperate to reduce FX Risk | American Express

 Additional Information
 Log In

United States Change Country

Terms of Service | Privacy Center | AdChoices | Security Center |

Card Agreements | Servicemember Benefits

All users of our online services are subject to our Privacy Statement and agree to
be bound by the Terms of Service. Please review.

© 2020 American Express. All rights reserved

https://www.americanexpress.com/us/foreign-exchange/articles/central-banks-cooperate-to-reduce-FX-risk/ 8/8