| Categories of |
| Financial risk |
|---|
 |
| Credit risk |
| Market risk |
| Liquidity risk |
| Investment risk |
| Business risk |
| Profit risk |
| Non-financial risk |
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Settlement risk, also known asdelivery risk orcounterparty risk, is therisk that acounterparty (or intermediary agent) fails to deliver asecurity or itsvalue in cash as per agreement when the security was traded after the othercounterparty or counterparties have already delivered security or cash value as per thetrade 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 ingood 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 aspolitical risk orsystemic risk may interrupt markets and prevent settlement, but these are not settlement riskper se.
One form of settlement risk is foreign exchange settlement risk or cross-currency settlement risk, sometimes calledHerstatt risk after theGerman 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 On 26 June 1974, the bank's license was withdrawn by German regulators at the end of the banking day (4:30pm local time) because of a lack of income and capital to cover liabilities that were due.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 paidDeutsche Mark to the bank during the day, believing they would receive US dollars later the same day in the US from Herstatt's USnostro. 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 ofDrexel 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 ofBarings Bank in 1995 resulted in minor losses for counterparties in theforeign exchange market because of a specific complexity in the ECU clearing system.
Settlement risk may be mitigated through various techniques, including:
