Settlement risk is the risk that a

counterparty A counterparty (sometimes contraparty) is a legal entity, unincorporated entity, or collection of entities to which an exposure of financial risk may exist. The word became widely used in the 1980s, particularly at the time of the Basel I delibera ...

(or intermediary agent) fails to deliver a

security Security is protection from, or resilience against, potential harm (or other unwanted coercive change) caused by others, by restraining the freedom of others to act. Beneficiaries (technically referents) of security may be of persons and social ...

or its value in cash as per agreement when the security was traded after the other

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 excha ...

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 Political risk is a type of risk faced by investors, corporations, and governments that political decisions, events, or conditions will significantly affect the profitability of a business actor or the expected value of a given economic action. P ...

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 the ...

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 On 26 June 1974, the bank's license was withdrawn by German regulators at the end of the banking day (4:30pm local time) because of a lack of income and capital to cover liabilities that were due.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 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 Drexel Burnham Lambert was an American multinational investment bank that was forced into bankruptcy in 1990 due to its involvement in illegal activities in the junk bond market, driven by senior executive Michael Milken. At its height, it was ...

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 LLC, known as Barings, is an international investment management firm owned by Massachusetts Mutual Life Insurance Company ( MassMutual). It operates as a subsidiary of MassMutual Financial Group, a diversified financial services organisa ...

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 asp ...

because of a specific complexity in the ECU clearing system.

Mitigation

Settlement risk may be mitigated through various techniques, including: *

Delivery versus payment Delivery versus payment or DvP is a common form of settlement for securities. The process involves the simultaneous delivery of all documents necessary to give effect to a transfer of securities in exchange for the receipt of the stipulated payment ...

. * Settlement through clearing houses. * Settling foreign exchange via a

special-purpose entity A special-purpose entity (SPE; or, in Europe and India, special-purpose vehicle/SPV; or, in some cases in each EU jurisdiction, FVC, financial vehicle corporation) is a legal entity (usually a limited company of some type or, sometimes, a limited ...

, 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