Settlement risk is the risk that a financial transaction will not be completed by the closing of the deal. It is a concern for financial institutions, investors, and traders, but can be reduced through the use of escrow accounts and instant settlement systems.
Settlement risk is the risk that a part of a financial transaction will not take place by the closing of the deal. It is a type of credit risk and is primarily a concern for financial institutions, investors, and traders that operate across multiple time zones. A number of steps have been taken with trading systems to reduce settlement risk with the goal of making it safer and easier to conduct financial transactions, such as creating instant settlement systems and using escrow accounts.
This type of risk is sometimes known as Herstatt risk, after an infamous example from the 1970s. Herstatt Bank in Germany did business internationally, and one day regulators closed the bank at the end of the German business day. When the German creditors had been paid because the bank settled their accounts during the day, the creditors in the United States suffered heavy losses because the bank was unable to pay them before it closed.
In a financial transaction, people agree to exchange commodities in some form for cash or commodities of equal value, such as cash for bonds, bi-currency currencies, etc. Both parties to the deal have something of value on offer, and something to lose if the other party doesn’t come to an agreement. Settlement risk, the risk that one party will default at the close of the deal, is a concern in transactions where one person delivers something before the other.
The use of escrow accounts, transaction insurance and the use of instant settlement systems can reduce settlement risk; A person selling securities, for example, transfers them and receives an instant payment in return through an electronic settlement system. Similarly, using regulators to monitor transactions and enforce the terms of a deal is another risk reduction tactic. In cases where people do not comply with the agreements, they can be taken to court if they do not respond to orders to comply with the agreement.
People consider liquidation risk when embarking on transactions. The adoption of instant standardized systems to handle the mechanics of settlements has radically reduced risk, but when people do big business or operate outside of a conventional settlement system, risk can become a bigger concern. The potential benefits of the agreement are weighed against the associated risks, and individuals decide whether they are willing to take those risks and whether there are any steps available to mitigate the risks, such as asking the other party to consider working with an escrow agent. .
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