Let's take a look at Herstatt Risk, a specific type of settlement risk in FX markets. We'll also look at how modern systems like CLS continuous linked settlement help address it. So what is Herstatt risk? Herstatt risk arises from the possibility that one party to an FX trade fulfills its obligation paying the currency it sold while the counterparty fails to deliver the currency that they sold. This risk is particularly pronounced in FX markets due to time zone differences, as currencies are typically settled in their respective domestic markets, which operate on different business hours. The term Herstatt risk originates from a real life event in 1974 involving the German bank, Bankhaus Herstatt. On June 26th, 1974 Herstatt Bank was declared insolvent during German business hours. Before its closure the bank had received payments in Deutschemarks from its counterparties, but it had not yet delivered the corresponding US Dollar payments. Because the US banking day had not yet begun, Herstatt's counterparties were left without their expected US Dollar funds when the bank ceased operations.

Let's consider a hypothetical trade between US Dollar and Japanese Yen to illustrate how Hearstatt risk can arise. US Dollar settlements typically occur during US business hours, while Japanese Yen settlements occur during Japanese business hours. If the Japanese Yen is delivered during Tokyo business hours, but something prevents the counterparty from delivering the US Dollars during New York business hours such as bankruptcy, one party is left exposed to loss.

To mitigate Herstatt risk. The CLS continuous linked settlement system was introduced. CLS is a global clearing and settlement system designed specifically to reduce FX settlement risk. Its main mechanism is called payment versus payment, or PVP, which ensures that both sides of an FX transaction are settled simultaneously. By doing so, CLS ensures that if one payment in a currency pair fails, the corresponding payment is also withheld preventing a loss to the counterparty. But how does it work? Instead of sending payments Directly to each other, counterparties send the currencies they owe to CLS. CLS then acts as an intermediary only releasing the payments to the counterparties once it has received both sides of the transaction. This way, the settlement occurs simultaneously even though payments may not have been made to CLS at the same time and eliminates the risk of one party fulfilling its obligations while the other fails to do so.

CLS provides settlement services for a select number of currencies determined by factors like trading volume, market demand, and regulatory approval. While CLS covers most major currencies, not all currencies are eligible. This limitation highlights the importance of being aware of potential settlement risks when trading less liquid or exotic currency pairs.

CLS membership is typically limited to major banks and financial institutions. However, non-members can still access CLS services indirectly through member banks.

CLS primarily settles FX spot, forward and swap transactions, ensuring secure and simultaneous settlements for these trade types.

By mitigating Herstatt risk, CLS has become a cornerstone of the FX market infrastructure, significantly enhancing the safety and efficiency of global currency transactions. However, its coverage is not universal, so market participants must remain vigilant about settlement risks, especially when trading non CLS eligible currency pairs.