Cross-currency settlement risk definition
What is cross-currency settlement risk?
Cross-currency settlement risk is a type of settlement risk where a party involved in a foreign exchange transaction sends the currency sold but does not receive the currency purchased. With cross-currency settlement risk, the full amount of the currency purchased is at risk. This risk exists from the time the financial institution issues an irrevocable payment instruction for the currency of sale until the time the currency of purchase is received in the account of the institution or its agent.
Cross-currency settlement risk is also known as Herstatt risk, after the small German bank whose bankruptcy in June 1974 highlighted this risk.
The central theses
- Cross-currency settlement risk is the potential for loss from a foreign exchange transaction where one currency pair is delivered but the second is not.
- With Forex trades, which take place 24 hours a day, the two sides of a currency transaction are not usually settled at the same time as it can be during the day for one side of the currency and in the middle of the night for the other.
- While losses from this occasionally occur, the actual risk involved in most cross-currency transactions is low.
- Cross-currency settlement risk is also known as Herstatt risk, after the small German bank whose bankruptcy in June 1974 highlighted this risk.
Understanding Cross-Currency Settlement Risk
One reason why cross-currency settlement risk is a concern is simply because of the different time zones around the world. Forex transactions are settled 24/7 around the world and time differences mean that the two sides of a currency transaction are generally not settled at the same time.
As an example of cross-currency settlement risk, consider a US bank buying 10 million euros in the spot market at the exchange rate of 1 EUR = 1.12 USD. This means that in the settlement, the US bank transfers $11.2 million and in return receives €10 million from the counterparty of this trade. Cross-currency settlement risk arises when the US bank issues an irrevocable money order for $11.2 million a few hours before receiving the $10 million in its nostro account to fully settle the trade.
Financial institutions manage their cross-currency settlement risk by having clear internal controls in place to actively identify risk. In general, the actual risk involved in most cross-currency transactions is low. However, when a bank is working with a smaller, less stable customer, it may choose to hedge the risk for the duration of the transaction.
Herstatt Bank and cross-currency settlement risk
Although a mistake in a cross-currency transaction is a small risk, it can happen. On June 26, 1974, German bank Herstatt was unable to make foreign exchange payments to banks with which it had done business that day. Herstatt had received Deutschmarks, but due to a lack of capital the bank stopped all US dollar payments. As a result, the banks that had paid the D-Mark were missing the dollars due. The German supervisory authorities acted quickly and revoked the banking license on the same day.
Whenever a financial institution or the global economy in general is under pressure, concerns about risk in cross-currency settlement arise. The 2007-2008 global financial crisis and the Greek debt crisis raised concerns about cross-currency settlement risk. Given how economically damaging both incidents were in other ways, currency settlement risk concerns proved comparatively overstated.