Continuous-linked settlement (CLS), the global system to reduce foreign exchange transaction risk, should have been set up to provide banks with a centralised clearing facility, rather than just to eliminate ‘Herstatt risk’, according to a senior banker at Dresdner Kleinwort Wasserstein (DrKW), the investment banking arm of Dresdner Bank.“They [CLS management] have not fully concluded what they need to, which is to bring foreign exchange into a fully cleared environment,” said Alex Wilkinson, global head of DrKW’s listed products group, at a briefing today.
Unlike other markets, such as equities, there is no central clearing facility for foreign exchange trades. Central clearing organisations guarantee trades by acting as the counterparty on both sides of a transaction. As they are typically highly rated, they lower the average credit risk associated with a trade. They also allow for anonymous trading regardless of how well capitalised a market participant is.
CLS is designed to settle trades on a net-funded basis over a period of time when country-specific real-time global settlement systems overlap.
Wilkinson said that when regulators pushed the world’s biggest banks to come up with a system to get rid of Herstatt risk – the risk that time-zone differences could lead to one party to a trade defaulting before it has paid out on its side of a contract – the banks involved “all got on the bandwagon”, without looking at what they would get for their money.
“The central banks said we need to eradicate Herstatt risk without realising that the best way to do it is through a central clearing environment, with all its add-on benefits,” added Wilkinson.
These benefits, he said, include increased liquidity and reduced capital requirements.
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