Settlement risk is most common in the foreign exchange market. Let’s go over how it works, a few examples, and how to mitigate the risk.
Definition and Examples of Settlement Risk
Settlement risk is the risk that the counterparty in a transaction will not deliver as promised even though the other party has already delivered on their end of the deal. Settlement risk is a subset of counterparty risk and is most widely considered in the foreign currency exchange markets.
Alternate name: Herstatt risk
Settlement risk exists when the contributions of both parties to a transaction are not cleared simultaneously. For example, if a U.S. bank or investor purchased euros from a European bank at 2 p.m. EST, the European bank may not be open to settle the transaction until the next day. If the bank failed in the interim, the original party would not receive the agreed-upon euros. Settlement risk is mitigated by the CLS, Continuous Linked Settlement Bank, a payment system created just for this purpose in 2002. The CLS holds the funds of the first party until funds have been received from the second party.
How Settlement Risk Works
There are two main types of settlement risk. Let’s start with the most severe.
Credit or Default Risk
The primary settlement risk is that the counterparty will go bankrupt prior to the transaction being settled, like the Herstatt Bank did in 1974. If the counterparty does default, it could take months or even years to recoup losses. Banks can attempt to mitigate this risk by underwriting the credit risk of counterparties.The Bank of International Settlements recommends treating foreign exchange transactions with settlement risk the same as any other credit risk.
Liquidity Risk and Settlement Lag
There is also a liquidity risk to foreign exchange transactions. Every minute a bank waits for the counterparty to contribute its side of the transaction is a minute those funds can’t be used for anything else. For normal transactions, this lag would be close to immaterial, but when global financial crises happen, banks can be spread too thin if too many transactions aren’t cleared in a timely manner. The CLS was founded in 2002 to solve both of these issues. CLS mitigates default risk by simply returning the principal amount to one party if the other party fails to deliver as agreed. It also attempts to mitigate the liquidity risk by transferring that principal back to the party in the currency that it would’ve received in the original transaction. This doesn’t totally eliminate liquidity risk, but it does make it so the bank doesn’t need to originate a new transaction.
Settlement Risk vs. Default Risk vs. Replacement Risk
Settlement risk, default risk, and replacement risk are the three parts of counterparty risk. Default, or credit, risk is the risk that the counterparty will fail to deliver because it goes bankrupt. For example, every time a bank makes a loan, there is a risk that the counterparty or borrower of the loan won’t pay it back. Replacement risk is the risk that if a counterparty defaults, there won’t be another opportunity to duplicate the same transaction. For example, many over-the-counter derivative transactions have a very limited number of potential counterparties. If one defaults, there may not be another to structure the same transaction, or the underlying asset may not make the same transaction attractive again. Settlement risk is the risk that the counterparty will default before the transaction has settled. It may seem like settlement risk and default risk are the same things. Settlement risk is most often used to describe the liquidity and Herstatt Bank-like risks of currency exchanges, while default risk is most often used to describe the possibility of a loan not being repaid.
What It Means for Individual Investors
Individual investors don’t often deal with material settlement risks—that risk is passed to middlemen such as market makers and brokers. Individuals who participate in over-the-counter derivatives and other financial transactions that are not on a marketplace may need to consider settlement risk. Want to read more content like this? Sign up for The Balance’s newsletter for daily insights, analysis, and financial tips, all delivered straight to your inbox every morning!
