Herstatt Risk - Explained
What is Herstatt Risk?
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What is Herstatt Risk?
Herstatt risk, also known as settlement risk or cross-currency settlement risk, is the risk associated with settlement of foreign exchange transactions. This type of risk was largely eliminated by the use of the Continuous Linked Settlement (CLS).
How Does Herstatt Risk Work?
The name is derived from the German Herstatt bank, which shuttered in 1974 for insolvency. Basically, the operations of the bank were suspended in the middle of a foreign currency exchange transaction. Because bank operations were suspended, individuals who had transferred currency to Herstatt Bank (deutschmarks) never received the agreed upon exchange currency (US dollars). So, the term Herstatt risk now refers to the risk of the transactional partner not settling the currency exchange. Herstatt risk exists because, historically, all foreign exchange (FX) transactions must be settlement in the home country of the currency. It does not matter where the parties trading the currency are located. This, along with time differences, can result in several hours between the time when a bank makes a transfer in one currency and receives a transfer in an alternative currency. This type of situation is rare, but the risk is ever present. A similar type of default and settlement failure took place in 1990 with the failure of Drexel Turnham Lambert, 1991 with BCCI, and 1995 with Barings. The use of Continuous Linked Settlement (CLS) virtually eliminated settlement risk. Under this system, each trading partner has an account with CLS Bank. CLS Bank acts as intermediary for the transaction. The parties are able to simultaneously make the trade or exchange transaction. The Bank creates a 5-hour window where all trading settlement process are open for all currencies. Settlement information information is readily available for a time period leading up to the transaction. This removes the time period and settlement risk from the transaction. If the settlement fails, the deposited currencies will be returned to the originating party.