Moving Money - Correspondent Banking and CLS

Part 3 of this short series explores the complex world of 'moving' money across borders and between currencies. This is perhaps the least well understood area of payments and one where the financial jargon is often extremely unhelpful.

Let's return to Alice wanting to make a payment to Bob, only this time Alice has a Sterling account with UK Bank A and Bob has a US dollar account with US Bank C. How can Alice instruct her bank to owe her a few less pounds and Bob's bank to owe him a few dollars more? If Bank A had a dollar account with Bank C then it could instruct C to adjust its books to transfer some of its debt from Bank A to Bob. However this would require every bank to fund and maintain an account with every other bank in every country it needed to send a payment to - not very practical.

Direct Method

Instead Bank A maintains a dollar account (which they call a Nostro account) with a large US bank, Bank B, whom it instructs to pay Bank C on its behalf. Banks B and C both have reserve accounts with the US Central Bank. This is called correspondent banking where Bank A is known as the Respondent and Bank B the Correspondent. Bank B refer to the account they hold on behalf of bank A as a Vostro account.

Let's work through an example. Bank A owes Alice ￡180. She wants to send Bob $50 so she asks Bank A to make the international payment for her. They offer her an exchange rate of $1.25:￡1 and she accepts. Bank A then reduces her balance by ￡40 and sends a SWIFT message to Bank B asking them to facilitate the payment to Bob at Bank C. Bank B reduces the balance of Bank A's account with them by $50 and then sends a Central-Bank settled payment to Bank C instructing it to pay Bob. The US Central Bank makes the adjustments like we saw in part 2 of our series. Once the transaction is complete the final position looks like:

Alice is owed ￡40 less by Bank A. Bank B now has $50 less reserves with the Central Bank and Bank C has an extra $50. Bob is now owed an additional $50 by Bank C. This payment chain is called the Direct Method and there can be several intermediary banks, or correspondent's correspondents, to find a path between A and C. Banks maintain a table of standard settlement instructions to determine how to route a payment to any other bank in the world via their correspondent accounts. If a bank is part of a larger international group then it may use an affiliate (another member of its own group) as its correspondent.

It is worth noting that using this method the quantity of UK sterling debt decreases, as Bank A has a reduced liability to Alice, whilst the total US dollar debt remains the same.

Cover Method

An alternative scenario arises where Bank C doesn't have an account with the Central Bank but maintains a US dollar account with Bank B. Bank C may be outside the US, i.e. offshore, in which case the dollar account is confusingly called a Eurodollar account. In this case a different approach, called the Cover Method is used.

As before, Alice instructs her bank to make the ￡40/$50 payment, agreeing to the exchange rate they offer. In this case Bank A sends two SWIFT messages: a payment message to Bank C and a institution transfer cover message to Bank B. Bank C is instructed to increase Bob's balance and told that their account with Bank B will be adjusted accordingly. Bank B makes the changes to its ledger, to owe Bank A $50 less and Bank C $50 more, and then sends a confirmation of credit message to Bank C. One reason for the two messages is to give Bank C the opportunity to pay Bob immediately, instead of waiting for the settlement confirmation from Bank B which can be delayed especially if a longer chain of intermediary banks is involved across different time-zones.

Foreign exchange can occur at other points along the payment chain, for example if an intermediary account in a third currency (typically US dollar) is needed to bridge between banks in two less well connected jurisdictions.

Once the transaction is complete the final position looks like:

Again it is worth noting that Bank C has an increased liability to Bob, denominated in US dollars. For Bank C to make dollar payments from Bob's Eurodollar (i.e. offshore dollar) account it must rely on its correspondent account with Bank B. This can cause confusion as Bank B's US dollar reserves used to make these payments are part of a closed system within the Federal Reserve, leading to the phrase that 'US dollars never leave the US'. In terms of US Central Bank money this is true, but it doesn't prevent a thriving market in dollar-denominated (Eurodollar) debt outside of the US.

Continuous Linked Settlement

Now you might be thinking - hang on... if Bank A didn't have access to the US dollar system to make dollar payments how did it acquire a balance of $100 with Bank B in the first place? One option is for it have agreed to swap pounds for dollars with a US bank. Imagine Bank A wants to swap pounds with Bank B for dollars. Bank A uses Bank C as its correspondent to hold US dollars and Bank B uses Bank D as it's correspondent to hold pounds.

Bank A can transfer pounds to Bank B's Nostro account with Bank D via the sterling settlement system. Bank B can transfer dollars to Bank A's Nostro account with Bank C via the dollar settlement system. However, this presents a difficulty as the two currency payment systems are distinct from each other and there is a risk (sometimes called Herstatt risk) that one side of the transaction completes whilst the other side fails due to the originating bank going bust.

Given the near instantaneous settlement of gross payments essentially one side must go first. This remains a problem for less frequently traded currency swaps today. However for more common currency pairs there is another type of bank, called CLS (Continuous Linked Settlement) Bank, that was set up to reduce the risk and link the two transactions together.

The CLS daily process begins with its member banks transferring funds, in each of the currencies they wish to trade, to their CLS accounts. CLS supports 18 different currencies and has connections to each Central Bank gross settlement system. CLS can then instruct the paired transactions to take place together with either both succeeding or, in the unlikely event of a failure, being rewound. Due to the volume of transactions taking place CLS nets off the payments, so each bank doesn't have to prefund its full daily transfer balance. At the end of the day all balancing payments are made and CLS balances return to zero.

This completes part 3 of our look at how money 'moves' around the global financial system. In the last part (for now at least) we will look at how funds are transferred to buy and sell securities.