Settlement Risk

When two parties exchange money or securities, the exchange may not happen at exactly the same moment. If one side pays and the other defaults before delivering, the first party can lose the full value of the transaction.

Settlement risk is particularly important in foreign exchange, where two currencies are exchanged, sometimes in different time zones. It is often called Herstatt risk, after a German bank, Bankhaus Herstatt, that was closed in 1974 after receiving payments in German marks but before paying out US dollars to its counterparties.

For example, a bank pays 10,000,000 euros to another bank in exchange for US dollars. If the second bank fails before paying the dollars, the first bank may lose the euros it sent.

Settlement risk is reduced through systems that link both sides of a transaction, such as payment versus payment in foreign exchange, through CLS Bank, and delivery versus payment in securities. Shorter settlement cycles and central counterparties also reduce the risk.