View source for Settlement risk

{{Short description|Risk that a party fails to deliver}}
{{Financial risk types}}
{{unreferenced|date=March 2017}}
'''Settlement risk''', also known as '''delivery risk''' or '''counterparty risk''', is the [[risk]] that a [[counterparty]] (or intermediary agent) fails to deliver a [[Security (finance)|security]] or its [[Value (economics)|value]] in cash as per agreement when the security was traded after the other [[counterparty]] or counterparties have already delivered security or cash value as per the [[trade]] 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]], 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]] or [[systemic risk]] 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 [[Herstatt Bank|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  On 26 June 1974, the bank's license was withdrawn by German regulators at the end of the banking day (4:30pm local time) because of a lack of income and capital to cover liabilities that were due.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]] in 1990 did not cause similar problems because the Bank of England had set up a special scheme which ensured that payments were completed. The collapse of [[Barings Bank]] in 1995 resulted in minor losses for counterparties in the [[foreign exchange market]] because of a specific complexity in the ECU clearing system.

==Mitigation==

Settlement risk may be mitigated through various techniques, including:

* Put limits on the amount of transactions to settle with each counterparty on a given day to avoid developing a large exposure to a single counterparty ;
* Settlement through a [[clearing house (finance)|clearing house]] to reduce the exposure and liquidity required by [[netting]] transactions (bilateral or multilateral) ;
* Requirement of initial margin deposits (also called "collateral deposits") and variation margin to provide a safety buffer ;
* Provide independent valuation of trades and collateral and monitor the creditworthiness of the member firms to enhance transparency and risk management ;
* Set up a guarantee fund that can be used to cover losses that exceed a defaulting member's collateral on deposit to offer an emergency solution ;
* Settlement through a [[central counterparty clearing]] to mutualize or transfer the settlement risk (cf. [[novation]]) ;
* Settlement via [[Delivery versus payment]] or [[Payment versus payment]] mechanism to avoid the settlement risk ;
* Settling foreign exchange via a [[special-purpose entity]], such as the [[CLS Group]].
* Settling via a cryptographic consensus system, such as a Blockchain. 

== External links ==
* [https://www.chicagofed.org/publications/understanding-derivatives/index Understanding Derivatives: Markets and Infrastructure] Federal Reserve Bank of Chicago, Financial Markets Group
* [https://web.archive.org/web/20120904161328/http://www.esma.europa.eu/ European Securities and Markets Authority]
* [http://www.europeanpayment.com Overview of Settlement Risks across Europe (26 countries)]
* [http://www.bis.org/cpss/ 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.

{{Financial risk}}

[[Category:Securities (finance)]]
[[Category:Financial risk]]
[[Category:Settlement (finance)]]

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