Settlement Risk

Explained:

Settlement risk is a form of credit risk that arises at the settlement of a transaction. Settlement often entails two parties both performing on respective obligations—say one party paying for a bond, and the other party delivering the bond. The risk is that one party may perform on its obligation but the other might not. Unlike pre-settlement risk, which entails exposure to the net value of the two obligations, settlement risk entails exposure to the entire value of a counterparty's obligation.

Settlement risk has historically been a particular problem in the foreign exchange markets because each currency must be delivered in its home country. Due to time zone differences, several hours can elapse between a payment being made in one currency and the offsetting payment being made in another currency.

A famous example of foreign exchange risk is the failure of Germany's Herstatt bank. On June 26, 1974, Herstatt had taken in all its currency receipts in Europe but had not made any of its US dollar payments when German banking regulators closed the bank down at the end of the German business day. Counterparties were left holding unsecured claims against the insolvent bank's assets. Consequently, risk is sometimes called Herstatt risk. Today, foreign exchange transactions are routinely settled through Continuous Linked Settlement, which eliminates settlement risk.

Settlement risk in any market can introduce liquidity risk. Banks that do not receive payments may need those funds to make payments to other parties. In the confusion that follows widespread failures, there is also the possibility of systemic risk. The failure of Bank Herstatt caused three days of disruption in the of foreign exchange transactions in New York.