FX settlement risk — also known as Herstatt risk — is the risk that one leg of an FX transaction settles but the other does not, because the counterparty defaults between paying one currency and receiving the other. For decades, this was the defining operational risk in FX markets, and the failure of Bankhaus Herstatt in 1974 gave it its name.
Bankhaus Herstatt and the origin of the risk
On 26 June 1974, West German regulators closed Bankhaus Herstatt — a small Cologne bank that had taken large speculative FX positions. The closure happened at 3:30pm Frankfurt time, which was 10:30am in New York. Many of Herstatt's counterparties had already paid Deutsche Marks to Herstatt (settlement in Frankfurt was complete), but Herstatt's correspondent bank in New York suspended outgoing USD payments just as the bank closed. Counterparties had paid their currency and received nothing in return.
The Herstatt failure demonstrated that FX settlement was structurally dangerous: because FX involves two currencies settling in different time zones and through different payment systems, there is always a window during which one leg has settled and the other has not.
CLS Bank: the multilateral solution
Continuous Linked Settlement (CLS) Bank, owned by a consortium of major financial institutions, was established in 2002 to eliminate settlement risk in FX. CLS uses a payment-versus-payment (PvP) mechanism: both legs of an FX transaction settle simultaneously, inside the CLS system, eliminating the window of risk.
CLS settles over trillion of FX transactions daily, across 18 currencies. It operates during a 5-hour window when the Asian, European, and North American payment systems all overlap. Participants submit their payment obligations to CLS; CLS calculates multilateral netting positions across all participants and currencies; and participants make and receive net payments across all their CLS transactions for the day.
The netting effect is dramatic: because CLS netts all obligations across all currency pairs and all transactions, participants may make and receive only a fraction of their gross transaction values.
Limitations of CLS
CLS does not cover all currencies or all transaction types. FX transactions in non-CLS currencies (many emerging market currencies) retain settlement risk. Cross-currency swaps, where settlement occurs across multiple dates over the swap's life, require careful management of each settlement leg. And participants that are not direct CLS members (smaller banks and corporates) settle bilaterally, retaining settlement risk for those transactions.