Settlement risk

Settlement risk, also known as counterparty risk, is the risk that one party in a transaction will fail to deliver the necessary funds or securities, leading to financial loss for the other party.
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Updated on Jun 10, 2024
Reading time 4 minutes

3 key takeaways

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  • Settlement risk arises when one party does not fulfill their obligations in a transaction, potentially causing significant financial losses.
  • This risk is prevalent in various financial markets, including securities, foreign exchange, and derivatives.
  • Effective risk management strategies, such as netting, collateral, and using central counterparties (CCPs), can mitigate settlement risk.

What is settlement risk?

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Settlement risk is the risk that a party involved in a financial transaction will not meet their obligations, resulting in financial loss for the other party. This can occur when one party fails to deliver the required securities, funds, or other financial instruments by the settlement date.

Settlement risk is a significant concern in financial markets, where the timely and accurate settlement of transactions is critical for market stability and participant confidence.

Causes of settlement risk

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Settlement risk can arise from various factors:

  • Counterparty default: The most common cause is the default or bankruptcy of the counterparty, rendering them unable to fulfill their obligations.
  • Operational failures: Technical glitches, human errors, or system failures can delay or prevent the settlement of transactions.
  • Timing differences: In cross-border transactions, differences in time zones and settlement cycles can create timing mismatches, increasing the risk of one party failing to deliver on time.
  • Liquidity issues: A party may face liquidity constraints, making it difficult to provide the necessary funds or securities for settlement.

These factors highlight the complexity of managing settlement risk in global financial markets.

Importance of managing settlement risk

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Effective management of settlement risk is crucial for several reasons:

  • Financial stability: Unmanaged settlement risk can lead to significant financial losses and systemic risk, potentially destabilizing financial markets.
  • Market confidence: Ensuring timely and accurate settlement of transactions maintains market participant confidence and promotes market integrity.
  • Operational efficiency: Efficient settlement processes reduce the risk of delays and operational disruptions, contributing to smoother market operations.

Proper risk management practices help mitigate the potential adverse effects of settlement risk.

Strategies to mitigate settlement risk

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Several strategies can be employed to mitigate settlement risk:

  • Netting: Netting reduces settlement risk by offsetting multiple obligations between parties, resulting in a single net payment or delivery. This minimizes the total exposure and the number of transactions requiring settlement.
  • Collateral: Requiring counterparties to provide collateral can mitigate the risk of default. Collateral acts as a security that can be used to cover losses if the counterparty fails to meet their obligations.
  • Central counterparties (CCPs): CCPs act as intermediaries between buyers and sellers in a transaction, assuming the counterparty risk. They guarantee the settlement of trades, reducing the risk for both parties.
  • Real-time gross settlement (RTGS) systems: RTGS systems process transactions individually in real-time, reducing the settlement lag and associated risks.
  • Settlement finality: Legal frameworks ensuring that once a transaction is settled, it cannot be unwound, providing certainty and reducing the risk of unsettled transactions.

Implementing these strategies helps minimize the potential impact of settlement risk on financial transactions.

Examples and case studies

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Examples of settlement risk and its management include:

  • Herstatt risk: Named after the collapse of the German bank Herstatt in 1974, this risk refers to the situation where one party in a foreign exchange transaction delivers the currency it sold but does not receive the currency it bought due to the counterparty’s default. The introduction of the Continuous Linked Settlement (CLS) system has significantly reduced Herstatt risk by ensuring simultaneous settlement of both sides of the transaction.
  • Lehman Brothers collapse: The 2008 collapse of Lehman Brothers highlighted the importance of managing settlement risk. Many counterparties were exposed to significant losses due to unsettled transactions. The crisis underscored the need for robust risk management practices and the role of CCPs in mitigating systemic risk.
  • Clearinghouses: Clearinghouses, such as the Options Clearing Corporation (OCC) and the London Clearing House (LCH), manage settlement risk by acting as central counterparties, ensuring the completion of transactions even if one party defaults.

These examples demonstrate the importance of settlement risk management in maintaining financial stability and market confidence.

Settlement risk is a critical concern in financial markets, arising from the potential failure of one party to meet their obligations. By understanding the causes and importance of managing settlement risk, and implementing effective mitigation strategies, financial institutions and market participants can protect themselves from significant financial losses and contribute to overall market stability.


Sources & references

Arti

Arti

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Arti is a specialized AI Financial Assistant at Invezz, created to support the editorial team. He leverages both AI and the Invezz.com knowledge base, understands over 100,000 Invezz related data points, has read every piece of research, news and guidance we\'ve ever produced, and is trained to never make up new...