Herstatt Risk in Foreign Exchange Trading

Highlights

• Definition and Origin: Herstatt risk, also known as settlement risk, arises when one party in a foreign exchange transaction fulfills its payment obligation, but the counterparty fails to do so.
• Impact on Financial Institutions: This risk can lead to significant financial losses and liquidity issues for banks and financial institutions engaged in international currency trading.
• Mitigation Strategies: Centralized settlement systems and regulatory measures have been developed to minimize Herstatt risk and enhance the stability of global financial markets.

Herstatt risk, also referred to as settlement risk, is a significant concern in foreign exchange trading. It occurs when one party in a currency transaction makes the agreed-upon payment, but the counterparty fails to deliver the corresponding currency. This can result in substantial financial losses and liquidity challenges, particularly for banks and financial institutions involved in international transactions.

Origin of Herstatt Risk

The term "Herstatt risk" originated from the collapse of Bankhaus Herstatt, a German bank, in 1974. On June 26 of that year, the bank was closed by German regulators after it had received Deutsche Marks (DEM) from its counterparties but before it could deliver the corresponding US Dollars (USD). This left counterparties without the expected USD payments, highlighting the vulnerability of settlement timing in global currency markets. The incident underscored the importance of coordinating payment timings across different time zones and jurisdictions, leading to increased awareness of settlement risk in foreign exchange trading.

How Herstatt Risk Occurs

Herstatt risk primarily arises due to time zone differences in global currency trading. When trading partners are located in different parts of the world, the payment of one currency may occur while banks in the country of the counter-currency are closed. For example, if a European bank sends EUR to its counterparty in New York during European business hours, but the corresponding USD payment is scheduled for later in the day (when European banks are closed), the European bank faces the risk of non-receipt if the New York counterparty defaults.

Impact on Financial Institutions

The impact of Herstatt risk on financial institutions can be severe, leading to:

• Financial Losses: If the counterparty fails to deliver the agreed currency, the institution may suffer substantial financial losses equivalent to the full amount of the trade.
• Liquidity Issues: The inability to receive expected funds can create liquidity problems, affecting a bank’s ability to meet its own payment obligations.
• Systemic Risk: In extreme cases, Herstatt risk can lead to a chain reaction of defaults, potentially triggering a financial crisis due to the interconnectedness of global banks.

Mitigation Strategies

To minimize Herstatt risk, the financial industry has implemented several strategies, including:

• Payment-versus-Payment (PvP) Systems: Systems like the Continuous Linked Settlement (CLS) Bank allow simultaneous settlement of both sides of a foreign exchange transaction, ensuring that payment occurs only if the counterparty’s payment is also made.
• Netting Agreements: These agreements allow parties to offset multiple transactions, reducing the overall settlement amount and risk exposure.
• Regulatory Oversight and Coordination: Central banks and regulatory authorities collaborate to enhance global payment systems, reducing the likelihood of settlement risk.

Conclusion

Herstatt risk remains a crucial consideration in international currency trading, primarily due to time zone differences and the complexity of cross-border financial transactions. While the financial industry has made significant strides in mitigating this risk through PvP systems, netting agreements, and enhanced regulatory oversight, continuous vigilance is necessary. As global markets evolve and new financial products emerge, the importance of robust risk management practices cannot be overstated. Financial institutions must remain proactive in adopting advanced settlement mechanisms and regulatory frameworks to safeguard against the recurrence of incidents like the Herstatt bank failure.