Settlement risk and finality across borders

Graduate · enrolled learners

This lesson opens with Bankhaus Herstatt, June 1974.

What happened

A cross-border currency trade has two legs in two currencies, and they do not settle at the same instant, because the two countries are in different time zones with different banking hours. Bankhaus Herstatt was a German bank that had entered such trades: counterparties paid it Deutsche Marks during the German business day, expecting to receive US dollars later that day in New York, where the market was still open. On 26 June 1974 German regulators closed Herstatt at the end of the German day, after it had received the Deutsche Marks but before its New York correspondent had paid out the dollars. The dollar payments were stopped, and counterparties who had already paid their side were left holding nothing for it, with roughly 620 million dollars in payments caught in the gap. The trade was sound and both legs were agreed; what failed was that one leg settled and became final while the other had not, and Herstatt ceased to exist in between. This became the textbook name for the risk: you can pay and not receive, because settlement across borders is not simultaneous.

The decision point

Settlement risk is the risk that arises because the two legs of a cross-border payment or trade do not become final at the same moment. When you settle one currency in one country and receive another in another country, time zones and banking hours mean one leg completes before the other, opening a window in which you have paid and not yet received. If the counterparty fails during that window, as Herstatt did, you have given up your side and gotten nothing, and the loss is the full principal, not a price movement. This is settlement risk, and its cause is the absence of simultaneous finality across borders: finality is a per-system, per-currency event, and two systems do not finalize together. Herstatt is the case that named it, and it drove the creation of payment-versus-payment settlement, where neither leg finalizes unless both do, precisely to close the gap. So the decision when settling across borders is to identify the window between your leg finalizing and the other's, and to reduce it, through payment-versus-payment arrangements, netting, or bounding who you are exposed to for how long, because in that window you are lending the full amount to a counterparty on trust, whether or not you meant to.

Recorded loss

$620,000,000

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