Settlement Risk

<body onLoad="MM_checkPlugin('Shockwave Flash','','http://www.riskglossary.com/default_nofl.htm',false);return document.MM_returnValue" stylesrc="../_private/template.htm" bgcolor="#FFFFFF" link="#669933" vlink="#000000" alink="#000000"> <div align="left"> <table border="0" cellpadding="0" cellspacing="0" style="border-collapse: collapse" bordercolor="#111111" width="100%" id="table1"> <tr> <td width="740"> <table border="0" cellpadding="0" cellspacing="0" style="border-collapse: collapse" bordercolor="#111111" width="100%" height="37" id="table2"> <tr> <td height="35" width="100%"> <table border="0" cellspacing="0" style="border-collapse: collapse" bordercolor="#111111" width="100%" cellpadding="0" id="table3"> <tr> <td width="100%" align="left" valign="top"> <p class="header_gold">Settlement Risk</td> <td width="45" align="right" valign="bottom"> <map name="FPMap6"> <area href="http://www.contingencyanalysis.com" shape="rect" coords="1, 0, 44, 11" target="_top"> </map> <img border="0" src="../images/home.gif" usemap="#FPMap6" width="45" height="12"></td> </tr> </table> </td> </tr> <tr> <td width="100%" bgcolor="#CC9966" height="2"> <img border="0" src="../images/blank_2x2.gif" width="2" height="2"></td> </tr> <tr> <td width="0%" valign="top" bgcolor="#FFFFCC"> <table border="0" style="border-collapse: collapse" bordercolor="#111111" width="100%" cellpadding="0" cellspacing="1" id="table4"> <tr> <td width="0%" align="left" valign="top"> <p class="header2_black">Explained:<br> <img border="0" src="../images/blank_1x100.gif" width="100" height="1"></td> <td width="0%" align="left" valign="top"><p class="word_list"> <a href="#Herstatt bank">Herstatt Bank</a><p class="word_list"> <a href="#Herstatt risk">Herstatt risk</a><p class="word_list"> <a href="#Settlement risk">settlement risk</a><br> <img border="0" src="../images/blank_1x160.gif" width="160" height="1"></td> <td width="100%" align="left" valign="top"><p class="word_list"> <br> <img border="0" src="../images/blank_1x160.gif" width="160" height="1"></td> </tr> </table> </td> </tr> </table> <table border="0" cellpadding="0" style="border-collapse: collapse" bordercolor="#111111" width="310" align="right" id="table5"> <tr> <td align="right" width="9" height="14"></td> <td width="300" height="14"> <font size="2"> </font><font size="4"> </font></td> </tr> <tr> <td align="right" width="9"> </td> <td width="300"> <script type="text/javascript"></script> <script type="text/javascript" src="http://pagead2.googlesyndication.com/pagead/show_ads.js"> </script>  </td> </tr> </table> <p class="body"><b><a name="Settlement risk">Settlement risk</a></b> is a form of <a href="../articles/credit_risk.htm">credit risk</a> that arises at the <a href="../articles/settlement.htm">settlement</a> of a transaction. Settlement often entails two parties both performing on respective obligations—say one party paying for a <a href="../articles/coupon_bond.htm">bond</a>, and the other party delivering the bond. The risk is that one party may perform on its obligation but the other might not. Unlike <a href="../articles/presettlement_risk.htm">pre-settlement risk</a>, which entails exposure to the net value of the two obligations, settlement risk entails exposure to the entire value of a counterparty's obligation.</p> <p class="body">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.</p>  <table border="0" cellpadding="0" cellspacing="0" style="border-collapse: collapse" bordercolor="#111111" width="345" align="left" id="table6"> <tr> <td width="336"> <script type="text/javascript"></script> <script type="text/javascript" src="http://pagead2.googlesyndication.com/pagead/show_ads.js"> </script>  </td> <td width="9"> </td> </tr> </table> <p class="body">A famous example of foreign exchange <img border="0" src="../word/settlemnt1.gif" align="absbottom" width="59" height="15"> risk is the failure of Germany's <b><a name="Herstatt bank">Herstatt bank</a></b>. 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, <img border="0" src="../word/settlemnt1.gif" align="absbottom" width="59" height="15"> risk is sometimes called <b><a name="Herstatt risk">Herstatt risk</a></b>. Today, foreign exchange transactions are routinely settled through <a href="../articles/continuous_linked_settlement.htm">Continuous Linked Settlement</a>, which eliminates settlement risk.</p> <p class="body">Settlement risk in any market can introduce <a href="../articles/liquidity_risk.htm">liquidity risk</a>. Banks that do not receive payments may need those funds to make payments to other parties. In the confusion that follows widespread <img border="0" src="../word/settlemnt1.gif" align="absbottom" width="59" height="15"> failures, there is also the possibility of <a href="../articles/capital_asset_pricing_model.htm">systemic risk</a>. The failure of Bank Herstatt caused three days of disruption in the <img border="0" src="../word/settlemnt1.gif" align="absbottom" width="59" height="15"> of foreign exchange transactions in New York.</p> <table border="0" cellpadding="0" cellspacing="0" style="border-collapse: collapse" bordercolor="#111111" width="100%" id="table7"> <tr> <td height="30" valign="bottom" colspan="2"> <p class="header2_black">Related Internal Links</td> </tr> <tr> <td colspan="2" bgcolor="#CC9966" height="2"> <img border="0" src="../images/blank_2x2.gif" width="2" height="2"></td> </tr> <tr> <td bgcolor="#FFFFCC" colspan="2"> <table border="0" cellspacing="0" style="border-collapse: collapse" bordercolor="#111111" width="100%" cellpadding="6" id="table8"> <tr> <td width="100%"> <p class="explanatory_text"> <img border="0" src="../images/bullet_link_glossary.gif" width="26" height="15"><a href="../articles/continuous_linked_settlement.htm">Continuous Linked Settlement</a> A settlement system for foreign exchange trades.<p class="explanatory_text"> <img border="0" src="../images/bullet_link_glossary.gif" width="26" height="15"><a href="../articles/credit_enhancement.htm">credit enhancement</a> Any methodology that reduces the credit risk of a transaction with a counterparty.<p class="explanatory_text"> <img border="0" src="../images/bullet_link_glossary.gif" width="26" height="15"><a href="../articles/credit_risk.htm">credit risk</a> Risk due to uncertainty in a counterparty's ability to meet its obligations.</p> <p class="explanatory_text"> <img border="0" src="../images/bullet_link_glossary.gif" width="26" height="15"><a href="../articles/derivative_instrument.htm">derivative instrument</a> An instrument which derives value from the value of some commodity, energy, or other financial instrument.<p class="explanatory_text"> <img border="0" src="../images/bullet_link_glossary.gif" width="26" height="15"><strong style="font-weight: 400"><a href="../articles/forward.htm">forward contract</a> A </strong>trade that is agreed to at one point in time but will take place at some later time.<p class="explanatory_text"> <img border="0" src="../images/bullet_link_glossary.gif" width="26" height="15"><a href="../articles/legal_risk.htm">legal risk</a> Risk from uncertainty due to legal actions or uncertainty in the applicability or interpretation of contracts, laws or regulations.<p class="explanatory_text"> <img border="0" src="../images/bullet_link_glossary.gif" width="26" height="15"><a href="../articles/netting.htm">netting</a> The offsetting of cash flows or other obligations against each other.</p> <p class="explanatory_text"> <img border="0" src="../images/bullet_link_glossary.gif" width="26" height="15"><a href="../articles/physical%20settlement.htm">physical settlement, cash settlement</a> Describes the two ways derivative instruments can settle.</p> <p class="explanatory_text"> <img border="0" src="../images/bullet_link_glossary.gif" width="26" height="15"><a href="../articles/settlement.htm">settlement</a> In finance, performance on a contractual obligation.</p> </td> </tr> </table> </td> </tr> <tr> <td height="30" valign="bottom" colspan="2"> <p class="header2_black">Related Papers</td> </tr> <tr> <td colspan="2" bgcolor="#CC9966" height="2"> <img border="0" src="../images/blank_2x2.gif" width="2" height="2"></td> </tr> <tr> <td bgcolor="#FFFFCC" colspan="2"> <table border="0" cellspacing="0" style="border-collapse: collapse" bordercolor="#111111" width="100%" cellpadding="6" id="table9"> <tr> <td width="100%"> <p class="explanatory_text"> <img border="0" src="../images/bullet_paper_glossary.gif" width="21" height="15">Basel Committee on Banking Supervision (2000). <a href="../papers/bcbs73.pdf">Supervisory guidance for managing settlement risk in foreign exchange transactions</a><p class="explanatory_text"> <img border="0" src="../images/bullet_paper_glossary.gif" width="21" height="15">Galati, Gabriele (2002). <a href="../papers/r_qt0212f.pdf">Settlement risk in foreign exchange markets and CLS Bank</a>, <i>BIS Quarterly Journal</i></td> </tr> </table> </td> </tr> <tr> <td height="30" valign="bottom" colspan="2"> <p class="header2_black">Sponsored Links</td> </tr> <tr> <td colspan="2" bgcolor="#CC9966" height="2"> <img border="0" src="../images/blank_2x2.gif" width="2" height="2"></td> </tr> <tr> <td bgcolor="#FFFFCC" width="75"> <img border="0" src="../images/ad_side_banner_2.jpg" width="103" height="285"></td> <td bgcolor="#FFFFCC" width="99%"> <script type="text/javascript"></script> <script type="text/javascript" src="http://pagead2.googlesyndication.com/pagead/show_ads.js"> </script>  </td> </tr> <tr> <td bgcolor="#FFFFCC" colspan="2"> <table border="0" cellspacing="0" style="border-collapse: collapse" bordercolor="#111111" width="100%" cellpadding="6" id="table10"> <tr> <td width="100%" bgcolor="#FFFFFF">  <p align="center"><map name="FPMap0_I1"> <area target="_top" 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