For many years, settlement risk was seen as unavoidable in cross-border investment and banking transactions, but this is changing.

Perhaps the best example of settlement risk is the case of Bankhaus Herstatt, a medium-sized German bank that was active in the foreign exchange (FX) markets. On 26 June, 1974, as a result of over-trading, the German authorities closed the bank at around 3.30pm local time. This meant that in New York, where markets had just opened, some of Herstatt's counterparties had paid deutschemarks but had not yet received dollars in return. As a result, exposed counterparties in the US lost an estimated $200m (€148m) and faced a long legal battle to recoup this in insolvency proceedings.

Herstatt's collapse also had knock-on effects, as other banks decided to wait to see if their counterparties could settle before they would make payments.

Similar cases of settlement risk arose with other collapses or events causing uncertainty, such as that of the Drexel Burnham Lambert Group in 1990, BCCI in 1991, Baring Brothers in 1995 and the dissolution of the Soviet Union in 1991.

It became clear that events such as these posed a danger of grid-lock in the banking system, as nervous bankers worried over the solvency of their counterparties. Suddenly banks and regulators realised that an individual case of settlement risk could have systemic implications, as uncertainty rippled outwards from the initial event.

Consequently, central banks, particularly the Bank of England and the Federal Reserve Bank of New York, looked hard at settlement risk. The Federal Reserve had a particularly strong interest. As the dollar is the largest currency traded in foreign exchange and the US market is the last to trade in the 24 hour cycle, the Fed would have to deal with the cumulative effects of a collapse. The US and the UK were also the two largest markets for FX, accounting for 70% of its total value.

Central bank concern was also heightened by research which showed exposure to settlement risk had previously been underestimated, as it was found it took an average of three days to process, match and reconcile FX trades, not one day as had been assumed.

In the words of CLS Bank executive vice-president, marketing and communication, Jonathan Butterfield: "When the daily value of FX trades was multiplied by three, not one, it produced a number which shook everybody up."

So by the mid-nineties, central bank pressure forced the banking industry to develop a better method for settling FX transactions and thereby reducing settlement risk. A group of major banks, known as the G20, worked on the issue and came up with the concept of CLS Bank. This was an ambitious project to enable ‘continuous linked settlement' for currency transactions, as part of an overall crackdown on settlement risk.

The essence of the CLS proposition is to match and settle the two legs of a transaction simultaneously, eliminating any time difference between paying and receiving that existed previously. If one side of a transaction pays up and other does not, then the paying side gets its money back immediately and the transaction has to be re-submitted.

Turning theory into reality on the scale required was a huge undertaking. Butterfield described the actual development of CLS Bank as "a long and fairly painful project. It turned out to have a degree of complexity to make it that nobody originally perceived."

But by September 2002, CLS Bank started operations in seven major currencies. Alongside setting up the technology, Butterfield said agreeing the operating standard, the participant legal agreement and the risk and governance models for all participants to comply with was a major achievement.

"If people break the rules, then you haven't solved the problem. The amazing thing about CLS Bank is not that it exists, but that people with strong vested interests have come together and agreed and compromised on how it should work. It works with a remarkable degree of consistency."

Now CLS Bank covers 15 currencies with Mexico and Israel due to join next year. According to Butterfield, at the end of the first quarter in 2007, CLS settled 350,000 instructions worth $3.5trn daily. At the last International Money Market quarter date, it settled 75,000 trades for a total value of $250bn for the fund management community.

The growth of CLS Bank and its ability to limit settlement risk has brought it to the attention of pension funds, fund managers and custodians involved in cross-border investment using FX. Here, awareness of its benefits is spreading, as more institutions make use of it.

Mohsin Siddiqi is investment operations technology co-ordinator at Newton Investment Management. Siddiqi said Newton was one of the first fund managers to use CLS Bank nearly four years ago.

"We do a lot of FX trading and a money is moving backwards and forwards. We were looking at ways of netting these amounts as a way of reducing settlement risk. Finding a mechanism to do this on an automated basis was proving quite difficult, and at the same time CLS appeared on our radar. We did much research, but it was a no-brainer."

Siddiqi added that using CLS Bank also allowed Newton to trade greater volumes with counterparties and freed up time in the back office that had previously been spent sorting out failed transactions.

"The issue from the fund management side is getting custodians on board, as they have been slower to adopt it. We hope more will be using it by the end of the year," he


Another fund manager that now uses CLS Bank is Record Currency Management, a specialist active currency fund manager with $40bn in assets under management. Record's managing director and chief operating officer, Peter Wakefield, commented: "We trade currency for our clients. As a result, settlement of those currencies, which we are responsible for together with custodians and bank counterparties, is a big issue for us in terms of risk."

Wakefield is also a fan of CLS Bank, saying it has solved these issues. "Once a trade is confirmed, it settles automatically, reducing the risk for our clients and reducing the admin burden for us."

Like Siddiqi, Wakefield says the custodians have been slow to get on board. "It is frustrating. Relatively few custodians are up and running with CLS for fund management activity."

He added that Northern Trust and Pictet are among the first custodians to do so, with others due to join them soon.

Large pension funds are also starting to make CLS Bank use a requirement for their managers and custodians, in order to reduce the fund's exposure to settlement risk.

AP1 is one of four buffer funds within the Swedish pension system, managing over €20bn of which 70% is invested in non-Swedish holdings. It also treats currencies as a separate asset class and has a long-term currency exposure of 20% of its total portfolio.

Due to concerns over settlement risk, AP1 approached its global custodian, ABN Amro Mellon Global Securities Services over participation in CLS.

Gum Hammerlund, head of back-office and accounting at AP1 commented: "As a significant pension fund that takes the safety and integrity of our funds very seriously, payment failure is not an acceptable option."

Siddiqi commented: "A few pension funds and trustees are now asking whether fund managers and custodians can support CLS. That's really going to wake people up."

He added that it is Scandinavian funds that are most aware of settlement risk, with the rest of Europe picking up on it. US pension funds are only slowly becoming aware.

Butterfield believes that fund managers and custodians will increasingly use CLS Bank to reduce their settlement risk levels in the future.

"If all your assets are in one currency, you don't need to consider it. But if do face the risk, why would you want to take it if you don't need to?"

Prior to CLS Bank's arrival, settlement risk could only be managed by using credit limits and monitoring counterparties. Now, fund managers and custodians have an industry solution to reduce the risks of anything happening at the wrong time affecting settlement. And for pension funds, asking their managers and custodians if they use CLS Bank to reduce settlement risk will become more common.

A final point is that, according to Butterfield, regulators are now taking a tougher line on other settlement issues, such as derivatives, where the speed of market growth has overwhelmed operational support and caused regulatory concerns.