Glossary term
Settlement Risk
Subject: Risk Management, Financial Risk (Credit, Market, Liquidity)
Also known as: Herstatt Risk
Settlement risk is the danger that one side of a trade pays or delivers but the other side fails to do so. The first party loses the full amount sent, not just the market movement.
Explanation
Many deals involve two transfers, such as currency against currency or securities against cash. If these happen at different times or in different systems, one party can be left exposed in between. The name Herstatt risk comes from a German bank closed by its regulator in 1974 after counterparties had already paid it deutsche marks but had not yet received US dollars. The loss is principal risk, which is far larger than ordinary replacement cost. The standard remedy is payment-versus-payment or delivery-versus-payment, where each leg is released only if the other is. Central counterparties and specialised settlement services use this idea. Firms also use netting and exposure limits for the gap that remains. Credit models built on replacement cost miss it, since the amount at stake is the whole payment and the window is short.
Example
Trading one currency for another with a counterparty in a different time zone, a bank pays out its leg in the morning, but the counterparty is declared insolvent before the matching payment arrives that afternoon. The bank has lost the full amount it sent. After the event it moves most of its trades to a service that settles both legs at once.
Not to be confused with
- Counterparty credit risk
- Counterparty credit risk covers loss from a partner defaulting over the life of a deal. Settlement risk is the loss of the amount delivered during the exchange itself.