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FRM Part II · FRM Exam Part II · Intraday Liquidity Risk Management

A bank trades a USD/EUR foreign exchange transaction and settles it through CLS (Continuous Linked Settlement). What is the primary risk that CLS's payment-versus-payment mechanism is designed to eliminate?

CLS uses payment-versus-payment settlement, so both currency legs of an FX trade settle simultaneously or not at all. This eliminates principal, or Herstatt, risk, where a bank delivers one currency but never receives the counter-currency because its counterparty fails.

  1. AInterest rate risk between trade date and settlement date
  2. BPrincipal (Herstatt) risk that one leg is paid while the other is not deliveredCorrect
  3. CMarket risk from exchange rate moves before the trade is executed
  4. DOperational risk of a bank's internal payment system failing

Explanation

CLS settles both currency legs simultaneously, only if both can be paid, so a bank cannot pay away one currency and fail to receive the other. This removes principal or Herstatt risk. It does not remove market risk before settlement or a bank's own internal failures.

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