Herstatt Risk – Definition

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Herstatt Risk Definition

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).

A Little More on What is Herstatt Risk

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.

References for Herstatt Risk

Academic Research on Herstatt risk

Measuring ‘Herstatt Risk, Kamata, S. (1990). Measuring ‚ÄėHerstatt Risk‚Äô.¬†Bank of Japan Monetary and Economic Studies,¬†8(2). This paper explores the general concept of Herstatt risk. The paper suggests that this risk occurs due to a delay in receiving currency by one party in a foreign exchange due to delivery lag. The paper analyses the causes of this risk, the ways in which it could be obtained, and the numerous ways of reducing this risk.

The payment system and derivative instruments, Perold, A. (1994). The payment system and derivative instruments. This paper examines the basic mechanisms in the financial system that function to manage the risks and costs associated with the clearing and settlement of securities transactions. The paper takes a broad view of the payment system, to include not just systems for clearing and settlement, but also derivative instruments, traditionally not viewed as integral to the payment system, except with the respect to their own clearing and settlement. The paper establishes that derivative instruments serve as an important extension of the payment system because they substitute in a variety of ways for trading in cash-market instruments.

What is systemic risk, and do bank regulators retard or contribute to it?, Kaufman, G. G., & Scott, K. E. (2003). What is systemic risk, and do bank regulators retard or contribute to it?. The Independent Review, 7(3), 371-391. This paper discusses the alternative definitions and sources of systemic risk, reviews briefly the historical evidence of systemic risk in banking, describes how financial markets have traditionally protected themselves from systemic risk, evaluates the regulations adopted by bank regulators to reduce both the probability of systemic risk and the damage caused by it if and when it may occur, and makes recommendations for efficiently curtailing systemic risk in banking.

Foreign exchange markets: Structure and systemic risks, Kodres, L. E. (1996). Foreign exchange markets: Structure and systemic risks. Finance and Development, 33(4), 22.

Systemic risk, SIFIs and financial stability, Lastra, R. M. (2011). Systemic risk, SIFIs and financial stability. Capital Markets Law Journal, 6(2), 197-213.

International Settlements: A New Source of Systemic Risk?, Eisenbeis, R. A. (1997). International Settlements: A New Source of Systemic Risk?. Economic Review-Federal Reserve Bank of Atlanta, 82, 44-50. This paper explores the degree of the study of systemic risks in the payment systems. The paper observes that one of the more interesting developments in this evolution has been the push, for several reasons, toward real-time gross settlement systems with collateralization.

E‚ÄźMONEY AND PAYMENT SYSTEM¬†RISKS, McAndrews, J. J. (1999). E‚ÄźMONEY AND PAYMENT SYSTEM RISKS.¬†Contemporary Economic Policy,¬†17(3), 348-357. This paper explores the risks and the benefits posed by the rapid development of new electronic systems of payment or e‚Äźmoney. The paper analyses different risks to which e-payment might be subject to, such as fraud, and legal risks, and declares these risks as challenging to the e-payment system.

Settlement risk in large-value payments systems, Shen, P. (1997). Settlement risk in large-value payments systems. Economic Review-Federal Reserve Bank of Kansas City, 82, 45-62. This paper explores how the large creation and use of electronic payment systems have caused settlement failures and potential impact of such failures. The paper examines settlement risk in large-value payments systems and discusses some of the measures available to manage such risk.

‘Trust is good, control is better’: The 1974¬†Herstatt¬†Bank Crisis and its Implications for International Regulatory Reform, Mourlon-Druol, E. (2015). ‚ÄėTrust is good, control is better‚Äô: The 1974 Herstatt Bank Crisis and its Implications for International Regulatory Reform.¬†Business History,¬†57(2), 311-334. This article offers the first comprehensive historical account of the Herstatt crisis, and contributes to the wider discussions on international supervisory and regulatory reform since the mid-1970s, including regulatory capture, markets’ self-regulation and resolution of failed banks. The article reveals that prior to the bank fall in June, 1974, that the Germans were warned about hersatt‚Äôs delaings. The article also explores the wider regulatory issues raised by the Herstatt case.

Risk and regulation in derivatives markets, Hentschel, L., & Smith Jr, C. W. (1994). Risk and regulation in derivatives markets. Journal of Applied Corporate Finance, 7(3), 8-22.

Financial intelligence in prediction of firm’s creditworthiness¬†risk: evidence from support vector machine approach, Benhayoun, N., Chairi, I., El Gonnouni, A., & Lyhyaoui, A. (2013). Financial intelligence in prediction of firm’s creditworthiness risk: evidence from support vector machine approach.¬†Procedia Economics and Finance,¬†5, 103-112. This paper seeks to explore the usefulness of financial indicators in measuring the financial health of companies and how to use these relevant attributes to design intelligent financial solution provided to investors and financial institutions to predict financial crashes.

Banking and payment system stability in an electronic money world, McAndrews, J. J. (1996, December). Banking and payment system stability in an electronic money world. In Conference on the Foundations of Policy Toward Electronic Money.

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