There is a debut in the offing.

A recently formed banker's bank, CLS Bank, is slated to launch a delicate operation in New York next year - CLS, or continuous linked settlement - that could banish or nearly banish foreign-exchange settlement risk. This would improve the stability of the global banking industry while increasing the depth of the foreign exchange market and trimming the cost of international trade and investment.

Settlement risk in foreign exchange occurs because a gap in time between the buying and delivery of currencies creates the possibility that a bank may not get the currency it bought, though it has already paid out the currency it sold.

The inability to get exchange that has been bought and paid for can subject a bank to a variety of ills, possibly culminating in its collapse, which in turn could trigger the dreaded domino effect of cascading global failures.

This prospect has greatly unnerved central bank regulators, who have been putting pressure on the foreign exchange heavyweights, like Deutsche Bank, Chase, and Citigroup, to devise a private solution to the problem. These banks' candidate for the job is continuous linked settlement.

As implemented by the new banker's bank, the procedure involves a payment-versus-payment matching system to erase the current time-gapped procedure. This system entails the simultaneous transfer of assets on the books of CLS Bank. Since sales will match purchases in real time, no one can be left hanging, at least in theory.

A much-needed security blanket will envelop the foreign exchange market, which has daily volume of around $1.7 trillion but has never enjoyed the luxury of real-time settlement so robustly in evidence in, say, the funds transfer market.

CLS Bank can spread this blanket because its shareholders include the previously mentioned foreign exchange heavyweights. Most of them are settlement members that will maintain multicurrency accounts with the bank to net their own and customer transactions at selected times each day. They will also serve user members (shareholders that can't settle) and third parties.

It is expected that, when continuous linked settlement is fully implemented, CLS Bank will settle about 60% of the global foreign exchange trading volume (in seven major currencies). What's more, that percentage is bound to increase over time, because banks that use the setup will have little settlement risk.

Since settlement risk subjects an institution to internal management capital charges and the periodic threat of formal levies by concerned regulators, there will be a powerful incentive for all banks to link up with CLS Bank or its settlement members. Quite obviously, the latter could pick up a lot of new business.

Helping to further concentrate the world banking industry may not be seen as an entirely unalloyed benefit, but the other consequences of continuous linked settlement will earn more universal plaudits.

For one thing, capital support is expensive. The cost burden is borne by the bank's shareholders and its customers, and the customer burden varies inversely with the competitive intensity of the banking industry.

To the extent that continuous linked settlement reduces the notional capital required to backstop settlement risk, the system will trim the cost of doing international business, especially in highly concentrated banking markets.

Settlement failures create liquidity problems in their wake and force traders to turn to their internal treasuries for the necessary funds coverage or to borrow from other banks. This generally has the effect of significantly reducing or even wiping out any trade profits.

If failures were eliminated, liquidity needs would be considerably pared, which would also reduce the cost of doing international business.

Additionally, the process of foreign exchange netting will cut the number of gross required payments. This will reduce bank transaction costs and circumscribe the level of balances that must be left with correspondent institutions.

With fewer payments, there will also be fewer chances for bank error, a happy thought when one remembers that error correction in a bank is disproportionately expensive.

Before this brave new world can materialize, however, bank settlement infrastructures must be upgraded and integrated in order to provide a real-time processing capability equal to the demands of the nascent real-time settlement environment.

The key vehicle for such an integration is a bit of middleware (programming that glues together otherwise separate programs) being built for CLS Bank by International Business Machines Corp. that will handle the flow of information among and between bank systems.

This middleware service will route data along the transaction life cycle without the need for manual intervention. Systems that otherwise would speak to each other fitfully, or not at all, should be able to communicate seamlessly.

However, getting to this stage will involve an estimated $100 million of information-technology enhancements for the major banks. To spend this money wisely, banks need to make astute vendor selections and commit themselves to exhaustive, pre-operational testing of the newly integrated systems.

Given the work required, it is conceivable that the advent of continuous linked settlement could be delayed beyond next year. Nonetheless, it is not likely to be delayed for very much longer. It is too valuable an initiative for the banking industry.

Within a very few years, the specter of multiple bank failures caused by what is essentially a bookkeeping glitch will be permanently exorcised by a three-letter acronym that is today little known outside bank foreign exchange departments.

Mr.Shildkraut is a manager in the New York office of Deloitte Consulting.

Subscribe Now

Access to authoritative analysis and perspective and our data-driven report series.

14-Day Free Trial

No credit card required. Complete access to articles, breaking news and industry data.