What is settlement risk?
Settlement risk is a type of risk that results from a breach of an agreement where one party fails to deliver according to the terms and conditions of a contract to the other party at the time of settlement. Settlement risk in simple term is the likelihood that your counter party will not pay you thus can lead to major risk.
Settlement risk was a common problem in the forex trade market where many traders were swindled of their cash from counter party agents who in most cases would not honor the initial contract agreement. It led to the establishment of a CLS continuously linked settlement facilitated by CLS Bank International that intervened to ensure it eliminates time differences in settlement creating a safer environment for trading in the forex market.
Settlement risk is commonly referred to as Herstatt risk. The name originated from a German bank called Herstatt which formed the basis of a case study in settlement risks. On June 26, 1974, Herstatt bank took its foreign currency receipts in Europe and had not made any U.S dollar payments by the time they received the news that the German banking regulators had revoked their license. The bank could not transact further and was forced to close its operation leaving counter parties with substantial losses.
How to Mitigate Settlement Risk
Delivery versus payment method
Settlement risk can result in huge losses thus it is important to come up with a settlement risk solution that can help minimize the risk of loss. One such method of mitigating against settlement risk is through the Delivery versus payment method also known as DvP. It is a common way of settlement for securities where for a delivery of one security to take place then the corresponding security must also be delivered. It’s an action reaction type of method where there is a simultaneous effect of give and take; there is no wait time. It is done to avoid settlement risk which may occur after one party fails to deliver security and the other party has already delivered the cash and vice versa when settling a security trade.
Central counterparty clearing
The other method through which settlement risk can be minimized is through the use of Central counterparty clearing also known as Central Counterparty, CCP. A central counterparty clearing is a financial institution such as a bank that provides clearing and settlement services for forex trade securities. The central counterparty acts as a link between two parties and helps reduce the risk when one party fails to honor its trade settlement obligations. A CCP does this by netting and offsetting transactions between multiple counterparties. For one to be able to transact through a central counterparty one is required to meet certain requirements such as make collateral deposits, must be credit worthy and must provide guarantors. All this can be used to cover losses in case of any default. The advantages of using a central counterparty to avoid settlement risk is that there is a lot of transparency, reduced processing costs and there is greater certainty in case of any default.