What is Settlement Risk?
Settlement risk -- also often called delivery risk -- is the risk that one party will fail to deliver the terms of a contract with another party at the time of settlement. Settlement risk can also be the risk associated with default, along with any timing differences in a settlement between the two parties. Default risk can also be associated with principal risk.
BREAKING DOWN Settlement Risk
Settlement risk is the possibility that one party fails to deliver or pay (the underlying asset or cash value of the contract) to another party in an exchange of securities. Settlement risk has historically been an issue in the foreign exchange (forex) market. The creation of continuously linked settlement (CLS) helped improve this. CLS, facilitated by CLS Bank International, eliminates time differences in settlement and is considered to have provided a safer forex market.
Settlement Risk and Herstatt Risk
Settlement risk is sometimes called "Herstatt risk," named after the well-known failure of the German bank Herstatt. On June 26, 1974, the bank had taken in its foreign-currency receipts in Europe but had not made any of its U.S. dollar payments. When German banking regulators closed the bank down, the event left counterparties with substantial losses. The case of the collapse of Herstatt led to the creation of the Basel Committee on Banking Supervision, consisting of representatives from both central banks and regulatory authorities in the Group of Ten (G10) nations. The Basel Committee is now headquartered within the Bank for International Settlements (BIS) in Basel, Switzerland and is generally considered to have formed the basis of banks' capital requirements in countries, represented by the committee and beyond.
Settlement risk is relatively rare; however, the perception of settlement risk can be elevated during times of global financial strain. For example, following the collapse of Lehman Brothers in September 2008, there was widespread worry that those invested with Lehman and expecting returns would not receive them.