Settlement Risk
Settlement risk is the risk that a payment or trade does not complete as expected because a party fails to deliver what it owes, on time or at all, after its counterparty has already performed.
Also called: principal risk · delivery risk · settlement exposure
The term covers two exposures. Principal risk is the loss of the full value handed over when nothing comes back. Liquidity risk is the cost of a late delivery: the money arrives eventually, but the party expecting it has to fund the gap in the meantime. Both exist in any arrangement where there is a delay between one side performing and the other.
The foreign exchange form is Herstatt risk. The same problem appears in securities, where it is handled by delivery versus payment, and in payment systems that settle on a deferred basis, where a participant may fail before the end-of-day settlement. See deferred net settlement.
Payment companies carry it whenever they pay out before they have been paid: crediting a merchant before the acquirer settles, releasing a payout against an incoming transfer that is not yet final, or prefunding a partner abroad. The controls are the same as a bank's: settle on a payment-versus-payment basis where possible, shorten the gap, set limits per counterparty, and know exactly when each incoming payment becomes irrevocable.
Commonly confused with
| Term | How it differs |
|---|---|
| Credit risk | Credit risk is the general chance a counterparty defaults over the life of an obligation. Settlement risk is the concentrated exposure during the hours or days when you have performed and they have not. |
See also
- Herstatt RiskHerstatt risk is the risk in a foreign exchange trade that one party pays the currency it sold but never receives the currency it bought, because the counterparty fails in between. The full principal amount is at stake.
- Payment versus PaymentPayment versus payment (PvP) is a settlement mechanism for foreign exchange in which the final transfer of one currency happens if, and only if, the final transfer of the other currency happens too. It removes the principal risk of paying first.
- Payment FinalityPayment finality is the point at which a transfer of funds becomes irrevocable and unconditional: it cannot be recalled by the sender, reversed by the system or unwound if a participant becomes insolvent. Before that point a payment is still a promise.
- Deferred Net SettlementDeferred net settlement (DNS) is a method in which a payment system collects payments over a period, offsets what participants owe each other, and settles only the net amounts at set times. It saves liquidity but delays finality.
- PrefundingPrefunding means placing money with a payout partner or correspondent before transactions are sent, so the partner can release funds locally without waiting for settlement to arrive. The balance is drawn down as payouts are made and topped up before it runs out.
- SettlementSettlement is the point at which value actually moves between parties and the obligation between them is discharged. It is a separate step from clearing, which only works out who owes what, and from finality, which is the moment the transfer can no longer be reversed.