Settlement risk
Encyclopedia
Settlement risk is the risk
that a counterparty
does not deliver a security
or its value
in cash per agreement when the security was traded after the other counterparty
or counterparties have already delivered security or cash value per the trade
agreement.
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 On 26th June 1974, the bank's license was withdrawn by German regulators at the end of the banking day (4:30pm local time) because of a lack of income and capital to cover liabilities that were due.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 4:30 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.
Risk
Risk is the potential that a chosen action or activity will lead to a loss . The notion implies that a choice having an influence on the outcome exists . Potential losses themselves may also be called "risks"...
that a counterparty
Counterparty
A counterparty is a legal and financial term. It means a party to a contract. A counterparty is usually the entity with whom one negotiates on a given agreement, and the term can refer to either party or both, depending on context....
does not deliver a security
Security (finance)
A security is generally a fungible, negotiable financial instrument representing financial value. Securities are broadly categorized into:* debt securities ,* equity securities, e.g., common stocks; and,...
or its value
Value (economics)
An economic value is the worth of a good or service as determined by the market.The economic value of a good or service has puzzled economists since the beginning of the discipline. First, economists tried to estimate the value of a good to an individual alone, and extend that definition to goods...
in cash per agreement when the security was traded after the other counterparty
Counterparty
A counterparty is a legal and financial term. It means a party to a contract. A counterparty is usually the entity with whom one negotiates on a given agreement, and the term can refer to either party or both, depending on context....
or counterparties have already delivered security or cash value per the trade
Trade
Trade is the transfer of ownership of goods and services from one person or entity to another. Trade is sometimes loosely called commerce or financial transaction or barter. A network that allows trade is called a market. The original form of trade was barter, the direct exchange of goods and...
agreement.
One form of settlement risk is foreign exchange settlement risk or cross-currency settlement risk, sometimes called Herstatt risk after the German bank
Herstatt Bank
Herstatt Bank was a privately-owned bank in the German city of Cologne. It went bankrupt on 26 June 1974 in a famous incident illustrating settlement risk in international finance....
that made a famous example of the risk. On 26th 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
Nostro
Nostro and vostro are accounting terms used to distinguish an account held for another entity from an account another entity holds...
. But after 4:30 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
Drexel Burnham Lambert
Drexel Burnham Lambert was a major Wall Street investment banking firm, which first rose to prominence and then was forced into bankruptcy in February 1990 by its involvement in illegal activities in the junk bond market, driven by Drexel employee Michael Milken. At its height, it was the...
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
Barings Bank
Barings Bank was the oldest merchant bank in London until its collapse in 1995 after one of the bank's employees, Nick Leeson, lost £827 million due to speculative investing, primarily in futures contracts, at the bank's Singapore office.-History:-1762–1890:Barings Bank was founded in 1762 as the...
in 1995 resulted in minor losses for counterparties in the foreign exchange market because of a specific complexity in the ECU clearing system.
Mitigating settlement risk
- Delivery versus paymentDelivery versus payment"Payment at the moment of delivery".Delivery versus payment or DVP is a sale transaction of negotiable securities that can be instructed to a settlement agent using SWIFT Message Type MT 543...
- Settlement via clearing housesClearing house (finance)A clearing house is a financial institution that provides clearing and settlement services for financial and commodities derivatives and securities transactions...
- Foreign exchange settlement using continuous linked settlementContinuous linked settlementContinuous Linked Settlement is a process by which a number of the world's largest banks manage settlement of foreign exchange amongst themselves . The process is managed by CLS Group Holdings AG and its subsidiary companies and include CLS Bank, a settlement bank regulated by the Federal Reserve...
For More Information
- European Securities and Markets Authority
- Overview of Settlement Risks across Europe (26 countries)
- Bank for International Settlements: Committee on Payment and Settlement Systems Forum for central banks to monitor and analyse developments in domestic payment, settlement and clearing systems as well as in cross-border and multicurrency settlement schemes. Excellent publications and research showing various forms of settlement risk and mitigation strategies.
- Overview: Settlement Risk is a more in-depth article.