Charles M. Kahn and William Roberds
Working Paper 2000-15a
November 2000
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Foreign exchange transactions are subject to a unique type of settlement risk. This risk ultimately stems from the difficulty of coordinating separate settlements in two different currencies. Settlement of foreign exchange transactions through the proposed CLS (“Continuous Linked Settlement”) Bank has been discussed as a potential solution to this problem. This paper describes the CLS proposal and analyzes the incentives it places on banks engaged in foreign exchange transactions. The analysis shows that while settlement through the CLS Bank may represent an improvement over current arrangements, some important problems associated with foreign exchange settlements will remain.
JEL classification: G20, F31
Key words: foreign exchange, settlement risk
This paper was prepared for the Carnegie-Rochester Series on Public Policy, April 2000. Research for this paper was begun while Roberds was visiting the Institute for Monetary and Economic Studies at the Bank of Japan. The authors thank Yoshiharu Oritani and Shuhei Aoki of the Bank of Japan and Darryll Hendricks and Jamie McAndrews of the Federal Reserve Bank of New York for explanations of the CLS settlement system. They also acknowledge the useful comments of Jeff Lacker, Larry Neal, Ed Stevens, the editor, and an anonymous referee, as well as participants in seminars and discussions at the Bank of Norway, the London School of Economics, Nuffield College Oxford, the Bank of England, the Bank for International Settlements, and the European Central Bank. The views expressed here are the authors’ and not necessarily those of the Federal Reserve Bank of Atlanta or the Federal Reserve System. Any remaining errors are the authors’ responsibility.
Please address questions regarding content to Charles M. Kahn, Department of Finance, University of Illinois, Urbana, Illinois, or William Roberds, Research Department, Federal Reserve Bank of Atlanta, 104 Marietta Street, N.W., Atlanta, Georgia 30303, 404-498-8970, 404-498-8956 (fax), william.roberds@atl.frb.org.