What Is Settlement Risk?

Settlement risk is the possibility that one or more parties will fail to deliver on the terms of a contract at the agreed-upon time. Settlement risk is a type of counterparty risk associated with default risk, as well as with timing differences between parties. Settlement risk is also called delivery risk or Herstatt risk.

Key Takeaways

  • Settlement risk is the possibility that one or more parties will fail to deliver on the terms of a contract at the agreed-upon time.
  • Settlement risk is usually nearly nonexistent in securities markets.
  • The two main types of settlement risk are default risk and settlement timing risks.
  • Settlement risk is sometimes called "Herstatt risk," named after the well-known failure of the German bank Herstatt.

Understanding Settlement Risk

In principle, settlement risk is simply the chance that a buyer or seller fails to keep their end of a deal. Whenever anyone buys goods online, there is the risk that the goods will show up late or never arrive. This risk is very similar to settlement risk in securities markets.

The idea of an "honest broker" who can be trusted to ensure that both parties keep an agreement is crucial for reducing settlement risk. Brokerage firms and individual brokers must maintain their reputations as honest brokers to stay in business. When most investors buy and sell securities, they are really dealing with their brokers rather than each other. Settlement risk is minimized by the solvency, technical skills, and economic incentives of brokers.

Settlement risk can be reduced by dealing with honest, competent, and financially sound counterparties.

Unsurprisingly, settlement risk is usually nearly nonexistent in securities markets. However, the perception of settlement risk can be elevated during times of global financial strain. Consider the example of the collapse of Lehman Brothers in September 2008. There was widespread worry that those who were doing business with Lehman might not receive agreed upon securities or cash.

Settlement risk has historically been an issue in the foreign exchange (forex) market. The creation of continuously linked settlement (CLS) helped improve this situation. CLS, facilitated by CLS Bank International, eliminates time differences in settlement and is considered to have provided a safer forex market.

Types of Settlement Risk

The two main types of settlement risk are default risk and settlement timing risks.

Default Risk

Default risk is the possibility that one of the parties fails to deliver on a contract entirely. This situation is similar to what happens when an online seller fails to send the goods after receiving the money. Default is the worst possible outcome, so it is really only a risk in financial markets when firms go bankrupt. Even then, U.S. investors still have Securities Investor Protection Corporation (SIPC) insurance.

Settlement Timing Risks

Settlement timing risks include potential situations where securities are exchanged as agreed, but not in the agreed-upon time frame. Settlement timing risks are generally far less serious than default risk, as transactions still take place. These risks are the securities market equivalent of everyday situations where a pizza or a package from Amazon shows up late. However, the speed and liquidity of financial markets make the consequences much more severe.

A Real World Example of Settlement Risk (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. It is generally considered to have formed the basis of bank capital requirements in countries represented by the committee and beyond.