First, the source of settlement risk is identified in two kinds of settlements; the “simple settlement” and “exchange-for-value settlement.” Second, the differences are clarified between “settlement risk” and “pre-settlement risk.” Third, the classifications of settlement risk is explained, which include “credit risk,” “liquidity risk,” “systemic risk,” “legal risk” and “operational risk.” Fourth, the differences are made clear between “principal risk” and “replacement cost risk.” Fifth, the actual examples are described, in which settlement risk turned into reality. They include the famous “Herstatt Bank incident,” “BCCI incident” and “Bearing incident.” Finally, the measures how to reduce settlement risk are discussed after identifying the exposures of settlement risk. Several mechanisms to reduce the risk, such as the netting, Payment versus Payment (PVP), and Delivery versus Payment (DVP), are described in detail.
TopOrigin Of Settlement Risk
A settlement is classified into two types. The first one is the “simple settlement,” in which funds are simply transferred from the payer to the payee. The second type is called the “exchange-for-value settlement,” in which funds are exchanged with other financial assets, such as foreign currencies or securities.
The origin of settlement risk differs according to the type.
Simple Settlement
“Simple Settlement” is a settlement in which funds are simply transferred from the payer to the payee. In this settlement, the delivery of equivalent value of the transferred funds, such as goods or services, are conducted in a different dimension from payment system. More simply put, if you order a shirt on the internet, the shirt will be delivered by a delivery service, like DHL. Then you will make a payment to the internet company using a payment system. At that time, the delivery service and payment system bear no relation.
In this simple settlement, the payment lag is the origin of settlement risk. “Payment lag” is a time-lag between the initiation of the payment order and its final settlement. In order to reduce settlement risk in this context, the time-lag should be shortened as much as possible.
Exchange-for-Value Settlement
“Exchange-for-value Settlement” is a settlement in which funds are exchanged with other financial assets, such as foreign currencies or securities. In this settlement, both a transfer of funds and delivery of assets take place. For example, the delivery of currency A and Currency B occurs in a foreign exchange (FX) settlement, and the transfer of funds and delivery of securities are executed in the securities settlement.
In the exchange-for-value settlement, a settlement lag is the origin of settlement risk. “Settlement lag” is a time-lag between a funds settlement and delivery of a financial asset. Such a situation could happen, in which a transfer of funds are made but cannot receive the counter financial asset, and vice versa. A mechanism in which the transfer of funds and delivery of assets are conducted simultaneously is quite useful in order to prevent such an awkward situation. These mechanisms are called “Delivery versus Payment” (DVP) for securities settlement and “Payment versus Payment” (PVP) for FX settlement (both will be discussed later).
Settlement Risk And Pre-Settlement Risk
Settlement Risk
Usually, “settlement risk” is a general term to designate the risk that a settlement will not take place as expected. Meanwhile, this term is sometimes used in a narrow sense. This usage means that a party cannot fulfill the settlement obligations on the due date. When the term of “settlement risk” is used in this narrow sense, the point is that the default will take place on the settlement date. As the settlement process is the final stage, the payment instructions are executed on the settlement date. In the case of an interbank payment, if the payer bank cannot transfer the funds as expected by the deadline of a payment system, the recipient bank will not receive the expected funds, which causes a liquidity shortage and unreasonable loss.