Settlement risk is the

risk In simple terms, risk is the possibility of something bad happening. Risk involves uncertainty about the effects/implications of an activity with respect to something that humans value (such as health, well-being, wealth, property or the environme ...

that a counterparty (or intermediary agent) fails to deliver a

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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 Trade involves the transfer of goods and services from one person or entity to another, often in exchange for money. Economists refer to a system or network that allows trade as a market. An early form of trade, barter, saw the direct exch ...

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 In human interactions, good faith ( la, bona fides) is a sincere intention to be fair, open, and honest, regardless of the outcome of the interaction. Some Latin phrases have lost their literal meaning over centuries, but that is not the case ...

, and otherwise competent to perform. 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 In finance, systemic risk is the risk of collapse of an entire financial system or entire market, as opposed to the risk associated with any one individual entity, group or component of a system, that can be contained therein without harming th ...

may interrupt markets and prevent settlement, but these are not settlement risk ''per se''. 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 On 26 June 1974, the bank's license was withdrawn by German regulators at the end of the banking day (4:30pm local time) because of a lack of income and capital to cover liabilities that were due.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 The Deutsche Mark (; English: ''German mark''), abbreviated "DM" or "D-Mark" (), was the official currency of West Germany from 1948 until 1990 and later the unified Germany from 1990 until the adoption of the euro in 2002. In English, it ...

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'' and ''vostro'' (from Italian, ''nostro'' and ''vostro''; English, 'ours' and 'yours') are accounting terms used to distinguish an account held for another entity from an account another entity holds. The entities in question are usually ...

. 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

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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 The foreign exchange market (Forex, FX, or currency market) is a global decentralized or over-the-counter (OTC) market for the trading of currencies. This market determines foreign exchange rates for every currency. It includes all as ...

because of a specific complexity in the ECU clearing system.

Mitigation

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.

External links

Understanding Derivatives: Markets and Infrastructure
Federal Reserve Bank of Chicago, Financial Markets Group
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. Securities (finance) Financial risk Settlement (finance) {{econ-stub