Why FX Transactions Did Not Freeze Up During the Global Financial Crisis

How can markets prevent counterparty failure from cascading into broad financial turmoil? This column looks at the seven-year-old clearing and settlement bank that handles 60% of foreign exchange transactions. The institution’s effective mitigation of counterparty risk throughout the financial crisis may be a model for a centralised derivatives trading exchange.

Administration officials have once again put the need for new trading systems for complex derivatives on the front burner. Officials are right to be concerned, as many new financial products represent contracts between two counterparties – banks, brokerage houses, insurance companies, and hedge funds, among others – without the benefit of a centralised exchange or clearinghouse. These bilateral deals develop in a “shadow banking system.” When institution A trades with B and institution A’s credit standing takes a hit, there is a direct impact on institution B. But there is a follow on impact on C and D (who trade bilaterally with B) and on E and F (who trade bilaterally with C and D), and so on. It is well known that organised futures and option markets utilise a well-capitalised central clearinghouse and a mark-to-market convention that imposes a daily discipline on traders and prevents credit events at firm A from cascading onto firms B, C and D. A famous illustration was in 1995 when Nicholas Leeson, a 28-year-old trader at Barings Brothers, lost $1.4 billion trading Nikkei index futures. The losses drove Barings (a 228-year-old institution and “Banker to the Queen”) into bankruptcy, but that did not threaten the market or any counterparty.

Far less well known is how the historic practice of bilateral trading (and bilateral clearing and settlement) posed a huge risk for another giant international financial market – the foreign exchange market – and how a new private institution (the CLS Bank) developed to counteract these risks and protect the foreign exchange market even in the face of a global financial crisis like the one we are now experiencing. The story is instructive in revealing not only how critical the new institution is to the steady operation of the foreign exchange (FX) market but also how long the process of developing something comparable for complex derivatives might take.

Credit risk in foreign exchange transactions

It is easy to appreciate that FX trading involves many risks. Like other asset prices, exchange rates are volatile, so the values of a trader’s or investment manager’s positions change moment-by-moment. But credit risk can be a far more serious, and even fatal, blow to a trading bank. And surprising as it may seem, this risk is in large part due to time zone differences and the fact that every foreign exchange transaction has two legs that occur in different countries.

Suppose a US bank (Yankee Bank) enters into an FX trade with a Japanese bank (Samurai Bank). Suppose that Yankee sells ¥100 million to Samurai for $1 million with delivery on Wednesday, February 25. On the delivery day, Yankee arranges to deliver ¥100 million to Samurai in Tokyo. This delivery takes place during Tokyo business hours, say 10 a.m. local time. When Yankee’s leg of the transaction is completed, it is usually 12-13 hours earlier in New York, meaning 9 or 10 p.m. on the prior day, when New York banks and the Federal Reserve are closed. It could be another 12-13 hours before Samurai’s payment of $1 million is delivered in New York.¹ And during those 12-13 hours, lots of things could happen, including the failure of Samurai Bank. If that were to happen, Yankee Bank would suffer a complete loss having paid out its entire leg of the transaction (¥100 million) to Samurai, but receiving nothing in return.

This scenario might seem dire and improbable. But it actually has happened in the foreign exchange market, and on more than one occasion, most famously in 1974 with Herstatt Bank, a privately owned bank based in Cologne, Germany. On June 26, 1974, counterparty banks around the world paid deutsche marks to Herstatt in Cologne expecting Herstatt to reciprocate and pay out US dollars during local banking hours in the United States. But Herstatt declared bankruptcy on June 26 and never fulfilled its leg of these FX transactions leaving numerous institutions (e.g. Morgan Guaranty Trust, Seattle First National, and Hill Samuel) with losses of tens of millions of dollars each.

This type of credit risk could be called delivery risk, but over the years, in the foreign exchange market it has been referred to as time-zone risk or more commonly “Herstatt risk.” There are two key elements. First, in the 1970s, banks relied on a multilateral clearing system. Each of the hundreds of banks trading foreign exchange potentially had counterparty transactions with hundreds of other banks, creating thousands of bilateral transactions. One failed bank could impact dozens or hundreds of counterparties. And second, time zone differences meant that banks further along in the 24-hour trading day were at risk from a bank failure occurring in an earlier time zone. Some solutions were proposed (e.g. require central banks to be open continuously to enable, at least in theory, simultaneously payment and collection in two parts of the globe) and others were implemented (e.g. spread any transaction across several business days to limit exposure to a delivery failure on any single trading day). But the ultimate solution only arrived when a new institution, the CLS Bank, was developed in the 1990s and launched in the fall of 2002.

How the CLS Bank mitigates delivery risk in the foreign exchange market

The innovation that solved the Herstatt risk problem is at once quite simple but also quite sophisticated. Think of a scene from a movie where two distrustful characters enter into a bet, where a condition is that their wagers are held by a third party (i.e. an honest broker) who can be trusted to pay off the wager when the outcome is determined. Delivery risk is thus removed because both counterparties have paid and released their funds to a reliable third party. In foreign exchange, the CLS Bank uses a similar payment-versus-payment system whereby payments from Yankee Bank to Samurai Bank (and vice-versa) are paid to the CLS Bank, not bilaterally. Only when both legs of the transaction are received does the CLS Bank make irrevocable payments to both counterparties. If one counterparty fails to produce its leg of the transaction, the other counterparty’s funds are returned in whole, thus eliminating the Herstatt risk.

The CLS in the bank’s name is an abbreviation for “continuous linked settlement,” the method by which the bank continuously collects transaction data from member counterparty institutions and matches them to determine if both sides of a transaction are completed, so final irrevocable settlement and payment can be made. Another feature of the CLS system is multilateral netting, meaning that bilateral transactions across counterparties can be netted out to reduce the actual payments and funds used in the system. CLS estimates that its netting efficiency is about 95%, meaning that for each trillion dollars of gross value settled only $50 billion of cash pay-ins are required.

To be effective at reducing Herstatt risk and not introducing any new risks, the credit standing and operating efficiency of the CLS Bank needs to be beyond reproach. The CLS Bank is a private institution, owned by a consortium of roughly 70 member banks from 22 countries. The CLS Bank is based in New York and operates under Federal Reserve Bank regulation. In addition to 60 settlement members, more than 4,000 other institutions participate in the system. Presently, the CLS Bank handles trades in 17 CLS-eligible currencies among CLS-eligible counterparties.

The CLS Bank estimates that they handle about 95% of their owners’ foreign exchange trades and 60% of all spot foreign exchange transactions worldwide. On their peak day in September 2008, in the midst of the global crisis, the CLS Bank handled more than 1.5 million instructions and settled transactions with a gross value of $8.6 trillion. In other words, near the peak of the freeze in interbank lending, the CLS Bank was handling a record volume of FX trades for thousands of counterparties – and all handled by a payment-versus-payment system, essentially free of Herstatt risk. And like a dog that didn’t bark, very few of us noticed the activity and efficiency of the CLS plumbing that protected the foreign exchange market from freezing up.

Foreign exchange markets expended trading during the crisis

In the fall of 2008, the financial crisis that began in the United State intensified and took on global dimensions. Financial markets froze as a growing list of financial institutions failed (e.g. Bear Stearns, IndyMac, Fannie Mae, Freddie Mac, Washington Mutual, Lehman Brothers, etc.). A rising crescendo of weak economic fundamentals spread fear about the quality and perhaps viability of many well-known financial players.

Against this backdrop, the foreign exchange market stayed vibrant, and activity levels rose relative to prior years. According to the semi-annual market survey prepared by the New York Foreign Exchange Committee, an industry group focused on business guidelines and best practices, overall FX trading volume in New York grew by 8.7% in October 2008 compared to the year earlier. And spot FX transactions grew by a full 27.0% over the same period. Data for London showed a similar result with overall daily trading volume rising by 21% relative to October 2007. According to the April 2007 BIS survey, global FX trading totalled almost $3.2 trillion per day with roughly 1/6 and 1/3 of that volume traded in New York and London, respectively. That a market so huge and so central to global economic activity was able to withstand the financial crisis, and in fact expand trading volume, demonstrates how potent the CLS Bank was at mitigating counterparty risks in foreign exchange clearing and settlement.


In the current financial crisis, financial losses and uncertainty severed the normal extension of interbank credit and lending among the world’s major banks. If this concern over bank credit worthiness had spread to foreign exchange, it would have dealt a serious blow to global trade and real economic activity over and above the impact of the financial crisis itself. Almost 35 years ago, the foreign exchange market experienced a shock that many years later led to the formation of a centralised, heavily capitalised clearing and settlement bank to handle transactions among a dispersed set of institutions trading in a multilateral marketplace. The CLS Bank effectively diffused the massive credit and counterparty risk that would haunt a marketplace with thousands of trading counterparties who exchange sums in the trillions on a daily basis. With less risk in a CLS-enabled trade, banks need less capital to support interbank trading, providing a natural incentive to use the CLS system.

It took many years and a substantial investment to develop and implement the CLS Bank system. But the new institution clearly proved its worth by keeping the financial crisis from infecting global trade in goods and services that relies on a well-functioning foreign exchange market. Recently, the CLS Bank has partnered with the Depository Trust and Clearing Corporation to facilitate the processing and settlement of certain over-the-counter credit derivatives. This is a useful step forward. A complete solution – allowing market economies to retain the benefits of trading in new financial derivatives without being subject to system-threatening shocks if one counterparty in a transaction fails in its obligations – will take more time and money. If only these investments had been made earlier.


1 Note the important role of the national bank clearing agents in the collection process. Japanese yen payments are cleared and settled through institutions in Japan, while US dollar payments are cleared and settled through institutions in the United States. If Samurai were to provide Yankee Bank with a USD check at 10 a.m. Tokyo time, the funds could not be confirmed as good funds until the United States banking system opened to process, collect and settle on the check. The situation is somewhat analogous to anyone asked to accept an out-of-town check, not knowing if it will be good once presented for collection.


•Foreign Exchange Joint Standing Committee, “Results of the Semi-Annual FX Turnover Survey in October 2008,” January 27, 2009.
•Foreign Exchange Committee, “Semi-Annual Foreign Exchange Volume Survey,” October 2008.

About Richard M. Levich 2 Articles

Affiliation: New York University

Richard M. Levich is Professor of Finance and International Business and Deputy Chair of the Department of Finance at New York University's Leonard N. Stern School of Business. He is also a Research Associate with the National Bureau of Economic Research in Cambridge, Massachusetts and a founding editor of The Journal of International Financial Management and Accounting now in its 19th year of publication.

Professor Levich has been a visiting faculty member at many distinguished universities in the United States and abroad including Yale University, the University of Chicago, Ecole des Hautes Etudes Commerciales (HEC) in France, the Australian Graduate School of Management of the University of New South Wales, and City University Business School in London. He has published more than fifty articles on various topics dealing with international finance, and is the author or editor of fifteen books. His textbook, International Financial Markets: Prices and Policies, second edition, was published in 2001 by McGraw-Hill/Irwin.

Professor Levich received his Ph.D. from the University of Chicago.

Visit: NYU Stern

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