Settlement risk can be defined as the possibility of a loss that arises when one party fails to honor its end of the deal. Therefore, the settlement in a transfer system will not be completed as expected. It can be as a result of defaulted payments or timing difference in a settlement. Parties to a contract ought to fulfill their promises during the settlement period. This is the period between the transaction and the settlement dates.
Types of Settlement Risk
Settlement risk is made up of credit and liquidity risks. Credit risk is whereby one party is unable to fulfill their promise on the agreed date or later because they are insolvent. Liquidity risk, on the other hand, is the risk that one party to a contract is unable to honor the promise at the agreed date but could fulfill their end of the bargain later. Therefore the main difference between credit risk and liquidity risk is that for liquidity risk the defaulting counterparty can honor their promise at a later date.
How to Mitigate Settlement Risk
Settlement risk can be mitigated in three ways
– Delivery versus payment: This is a mitigation measure where parties to the contract honor their promises simultaneously. For instance, in securities, the parties exchange documents for the transfer and the agreed payment amount simultaneously. With simultaneous delivery, the risk of one party failing to honor their promise is eliminated.
– Settlement via special purpose entities: Special purpose entities are legal entities used by companies to mitigate settlement risk. Example of special purpose entity is the CLS Group. CLS group caters for settlements in the foreign exchange market. Since the foreign exchange market does not have a central clearing platform, most traders use CLS to settle their transactions so as to mitigate risk.
– Settlement through settlement risk solution services.
Settlement Risk Example
A good example of a settlement risk is the case of Herstatt Bank that failed causing a huge financial crisis. The bank was opened in 1956 by Iwan Herstatt and Hans Gerling. The investment grew and became the 35th largest bank in Germany. The bank had a foreign exchange department that operated without the control and collaboration with other divisions.
In 1974, Herstatt Bank failed causing failures in other banks that relied on them for delivery of foreign currencies. The cause of the problem was attributed to the huge foreign exchange exposure which was eight times higher than the limit. Consequently, the bank’s license was withdrawn in June 1974 as the bank lacked assets to cover the liabilities.
The huge liability was as a result of flawed methods applied by the bank when speculating the dollar movement. On the day the bank’s license was withdrawn, some other banks had paid Deutsche Mark to the Herstatt with the hope of getting US dollars later in the day. However, Herstatt stopped all dollar transactions at 3.30pm, that is 10.30 am in New York, and thus counterparties did not receive their dollars. This kind of risk is today referred to as Herstatt risk. The bank’s crisis resulted in a number of regulations. For instance, the banking act was amended, and a deposit protection scheme was set up for German banks.