Cross-Currency Settlement Risk
Contents
Demystifying Cross-Currency Settlement Risk
Understanding Cross-Currency Settlement Risk
Cross-currency settlement risk, also known as Herstatt risk, poses a potential threat in foreign exchange transactions where one currency is delivered, but the counterpart currency is not received. This risk arises due to the asynchronous nature of global forex trading, where time zone disparities can lead to delays in settlement.
Key Takeaways
- Cross-currency settlement risk arises when one currency is delivered in a foreign exchange transaction, but the counterpart currency is not received.
- Time zone differences contribute to the likelihood of asynchronous settlement in forex trades.
- Despite occasional losses, the overall risk of cross-currency settlement risk is relatively low for most transactions.
Navigating Cross-Currency Settlement Risk
The inherent challenge of cross-currency settlement risk stems from the 24/7 nature of forex trading, resulting in non-simultaneous settlement of currency pairs. For example, a U.S. bank purchasing euros may face risk if it remits payment before receiving the euros, potentially leading to financial exposure.
Mitigating Cross-Currency Settlement Risk
Financial institutions employ internal controls to actively identify and manage cross-currency settlement risk. While the risk is generally minimal, institutions may hedge exposure, especially when dealing with less stable clients.
Herstatt Bank and Historical Context
The 1974 failure of Herstatt Bank underscored the potential consequences of cross-currency settlement risk. Herstatt's inability to fulfill U.S. dollar payments left counterparties without the expected funds, prompting swift regulatory intervention. Subsequent crises, such as the 2007-2008 Global Financial Crisis and the Greek debt crisis, reignited concerns about currency settlement risk.