Continuous Linked Settlement: History and Implications

This thesis is a contribution to the academic literature regarding post-trade activities in the foreign exchange market. The international foreign exchange market is the largest market in the world. Its volume is six times the trading volume of the second largest market, the U.S. Treasury securities market. Since there are always two parties to each foreign exchange transaction, the volume to be settled is even twice the trading volume. In foreign exchange trading, it is not uncommon for two banks to owe each other 2 billion US Dollar overnight because settlement has not yet been completed. The figures make clear that reliability and resilience of the settlement processes are essential. Interruptions or delays may have disastrous consequences for the financial industry. During the past years, financial authorities have started to realize the system's vulnerability and increasingly paid attention to post trade activities in general and to settlement practices of foreign exchange in particular. In the nineties, several publications have highlighted that most banks had tremendous overnight credit risk exposures due to current settlement and reconciliation practices at that time. Regulators called on the financial industry to take appropriate action to measure and reduce the settlement risks in the foreign exchange market. Since then, the international financial industry has heavily invested in operations and technology to comply with regulators' requests. The most important result from these common industry efforts is the implementation of the Continuous Linked Settlement (CLS) system. Briefly, CLS is specifically designed to eliminate credit risk on foreign exchange transactions that it settles. A payment-versus-payment settlement mechanism combined with a number of risk management provisions eliminates credit risk exposures. The elimination of credit risk, however, brought a number of other changes to the market. This thesis deals with the most important aspects of the CLS system in general and its implications for the market. It provides an in depth description of CLS's functionality, documents the history of its implementation, and looks into its transaction structure. The goal of this thesis can thus be split in four parts: (1) Provide a description of CLS' history, (2) deliver an in depth description of its functionality, (3) assess CLS's achievement in reducing credit risk, and (4) analyze the evolvement of its transaction structure and pick up some liquidity issues. These four parts together form a comprehensive overview of the CLS system. It must be mentioned that this thesis does not explicitly focus on operational risks or corporate governance issues nor on systemic risk aspects. They may be a component part of the thesis but are not addressed separately. The thesis concludes that CLS is a success story. Once running, the system proved its resilience and was able to successfully penetrate the market. Around 60 percent of global foreign exchange turnover is estimated to be settled in CLS. If this equals a 60 percent credit risk reduction, the urge of the Bank for International Settlements may be considered to be well fulfilled. The empirical part of the thesis offers insights into the trading structure among CLS members. Substantial differences in the structure of settlement member and third party relationships were found. Settlement members are highly connected among each other and do not show significant changes over time. The connectivity of third parties is much lower and shows the development of power law characteristics. Statistics and visualized network graphs suggest that new third parties tend to be smaller than the existing ones. This means that a relatively small group of members generates an increasing part of the business. In terms of liquidity, the analysis was based on the bilateral net sell position. The fact that these positions did in average not lower during the past years, indicates that simply increasing the number of members does not automatically lead to lower bilateral net sell positions. In contrast, cross sectional regression suggests that there is a certain dependency between the level of the bilateral net sell position and the type of trade relation. It seems that trade relations between members with high relative connectivity lead to lower bilateral net sell positions. If and how these results may be implemented in a practical context is yet unclear.