What is Settlement Risk?
Settlement risk is the risk that one party will fail to deliver the terms of a contract with another party at the time of settlement. Settlement risk can be the risk associated with default at settlement and any timing differences in settlement between the two parties. This type of risk can lead to principal risk.
Settlement risk is the risk that a counterparty (or intermediary agent) fails to deliver a security or its value in cash as per agreement when the security was traded after the other counterparty or counterparties have already delivered security or cash value as per the trade agreement. The term covers factors incidental to the settlement process which may suspend or prevent a trade from completing, even though the parties themselves are in agreement, are acting in good faith, and otherwise competent to perform.
Settlement risk is most often associated with currency trading. However, it can also apply to any contractual deal between two parties. Settlement risk is the risk taken by each party in a contractual transaction that the other party will not uphold their end of the bargain (e.g. monetary payment or delivery of goods/services).
The term applies only to risks inherent to the settlement method of a particular transaction. Broader risks of trading such as political risk or systemic risk may interrupt markets and prevent settlement, but these are not settlement risk per se.
Settlement risk is the possibility your counter party will never pay you. Settlement risk was a problem in the forex market up until the creation of continuously linked settlement (CLS), which is facilitated by CLS Bank International, which eliminates time differences in settlement, providing a safer forex market.
Settlement risk is the risk that a settlement in a transfer system does not take place as expected. Generally, this happens because one party defaults on its clearing obligations to one or more counterparties. As such, settlement risk comprises both credit and liquidity risks. The former arises when a counterparty cannot meet an obligation for full value on due date and thereafter because it is insolvent. Liquidity risk refers to the risk that a counterparty will not settle for full value at due date but could do so at some unspecified time thereafter; causing the party which did not receive its expected payment to finance the shortfall at short notice. Sometimes a counterparty may withhold payment even if it is not insolvent (causing the original party to scramble around for funds), so liquidity risk can be present without being accompanied by credit risk.
One form of settlement risk is foreign exchange settlement risk or cross-currency settlement risk, sometimes called Herstatt risk after the German bank that made a famous example of the risk. On 26 June 1974, the bank’s license was withdrawn by German regulators at the end of the banking day (4:30pm local time) because of a lack of income and capital to cover liabilities that were due. But some banks had undertaken foreign exchange transactions with Herstatt and had already paid Deutsche Mark to the bank during the day, believing they would receive US dollars later the same day in the US from Herstatt’s US nostro. But after 3:30 pm in Germany and 10:30 am in New York, Herstatt stopped all dollar payments to counterparties, leaving the counterparties unable to collect their payment. The closing of Drexel Burnham Lambert in 1990 did not cause similar problems because the Bank of England had set up a special scheme which ensured that payments were completed. Barings in 1995 resulted in minor losses for counterparties in the foreign exchange market because of a specific complexity in the ECU clearing system.
Mitigation of Settlement Risk
Settlement risk may be mitigated through various techniques, including:
- Delivery versus payment.
- Settlement through clearing houses.
- Settling foreign exchange via a special-purpose entity, such as the CLS Group.