Definition and Examples of Settlement Risks
How Settlement Risks Work
Settlement Risks vs. Assumption and Replacement Risks
What Does This Mean for Individual Investors
Definition and Examples of Settlement Risks
Settlement risks are the risks faced by one party in a financial transaction that may be unable to fulfill its side of the deal by failing to deliver the required cash or security to complete the transaction. Settlement risks may also occur when there is a delay in payment from one party, usually due to time zone differences.
Settlement risks are most common in the foreign exchange market. Let’s look at how they work, some examples, and how to mitigate this risk.
How Settlement Risks Work
There are two main types of settlement risks. Let’s start with the more severe one.
Credit or Assumption Risks
The primary risk of settlement is that the other party may go bankrupt before the transaction is completed, as happened with Herstatt Bank in 1974. If the other party defaults, recovering losses may take months or even years.
Banks can mitigate this risk by taking credit risks for counterparties. The Bank for International Settlements recommends treating foreign exchange transactions that involve settlement risks in the same way as any other credit risks.
Liquidity Risks and Delayed Settlement
There are also liquidity risks in foreign exchange transactions. Every minute the bank waits for the other party to contribute its side of the transaction is a minute that those funds cannot be utilized for anything else. For routine transactions, this delay may be almost insignificant, but during global financial crises, banks can be significantly impacted if many transactions are not settled in a timely manner.
CLS was established in 2002 to address these two issues. CLS reduces assumption risk by returning the principal amount to one party only if the other fails to deliver as agreed.
Settlement Risks vs. Assumption and Replacement Risks
Settlement risks, assumption risks, and replacement risks are three components of counterparty risk.
Assumption or credit risk is the risk that the counterparty will fail to deliver due to bankruptcy. For example, every time a bank lends an amount of money, there is a risk that the counterparty or borrower will not pay it back.
Replacement risk is the risk that if the counterparty defaults, there will not be another opportunity to replicate the same transaction. For example, many over-the-counter derivatives transactions have a very limited number of potential counterparties. If one defaults, there may not be another party to arrange the same deal, or the underlying asset may not be attractive enough to repeat the same trade.
Settlement risk is the risk that the counterparty will fail before the transaction is settled. Settlement risk and assumption risk might seem to be the same thing. The term settlement risk is mainly used to describe liquidity risks and the Herstatt Bank risk in foreign exchange, while the term assumption risk is mainly used to describe the likelihood of a loan default.
What Does This Mean for Individual Investors
Individual investors often do not deal with significant settlement risks – this risk is passed on to intermediaries such as market makers and brokers.
Individuals participating in over-the-counter derivatives and other financial transactions that are not conducted on an exchange may need to consider settlement risks.
Acknowledging settlement risks is extremely important for investors and traders in financial markets. Investors should be aware of potential risks and how to effectively manage them to protect their funds and achieve the desired returns.
Article Summary: Settlement risks are the risks that one party faces in a financial transaction that may be unable to fulfill its side of the deal by failing to deliver the required cash or security to complete the transaction. There are two main types of settlement risks: credit or assumption risks and liquidity risks and delayed settlement. Individual investors should be aware of settlement risks and how to effectively manage them.
Source:
https://www.thebalancemoney.com/what-is-settlement-risk-5224243
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