DEFINITION of Cross-Currency Settlement Risk
Cross-currency settlement risk is a type of settlement risk in which a party involved in a foreign exchange transaction remits the currency it has sold but does not receive the currency it has bought. In cross-currency settlement risk, the full amount of the currency purchased is at risk. This risk exists from the time that an irrevocable payment instruction has been made by the financial institution for the sale currency, to the time that the purchase currency has been received in the account of the institution or its agent.
Also called Herstatt risk, after the small German bank, whose failure in June 1974 exemplified this risk.
BREAKING DOWN Cross-Currency Settlement Risk
One reason for this risk is the difference in time zones. With foreign exchange trades globally conducted around the clock, time differences mean that the two legs of a currency transaction will generally not be settled simultaneously.
As an example of cross-currency settlement risk, consider a U.S. bank that purchases 10 million euros in the spot market at the exchange rate of EUR 1 = USD 1.40. This means that at settlement, the U.S. bank will remit US$14 million and, in exchange, will receive EUR10 million from the counterparty to this trade. Cross-currency settlement risk will arise if the U.S. bank makes an irrevocable payment instruction for US$14 million, a few hours before it receives the EUR10 million in its nostro account, in full settlement of the trade.
On June 26, 1974, German bank Herstatt was unable to make foreign exchange payments to banks it had engaged in trades with that day. Herstatt had received Deutsche Mark, but due to lack of capital, the bank suspended all U.S. dollar payments. This left those banks that had paid Deutsche Mark without the dollars it was due.
The German regulators were swift in their actions, withdrawing the banking license that day.