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Settlement risk is a risk that a party to a financial transaction will fail to perform at the close of the deal. It is a type of credit risk and is primarily a concern for financial institutions, investors, and traders operating across multiple time zones. A number of steps have been taken with trading systems to reduce settlement risk with the goal of making it safer and easier to engage in financial transactions, such as creating instant settlement systems and using escrow accounts.
This type of risk is sometimes known as Herstatt risk, after an infamous example from the 1970s. The Herstatt Bank in Germany did business internationally, and one day regulators closed the bank at the end of the German business day. When German creditors had been paid because the bank settled its accounts during the day, creditors in the United States took large losses because the bank was unable to pay them before it was closed.
In a financial transaction, people agree to exchange commodities of some form for cash or commodities of equal value, like cash for bonds, foreign exchange in two currencies, and so forth. Both parties to the deal have something of value on offer, and something to lose if the other party fails to settle. Settlement risk, the risk that one party will default at the close of the deal, is a concern in transactions where one person hands something over before the other.
Using escrow accounts, insuring transactions, and utilizing instant settlement systems can all reduce settlement risk; a person selling securities, for example, transfers the securities and receives an instant payment in return through an electronic settlement system. Likewise, using regulators to oversee transactions and enforce the terms of a settlement is another risk-reduction tactic. In cases where people default on settlements, they can be taken to court if they do not respond to orders to make good on the settlement.
People consider settlement risk when embarking on transactions. The adoption of instant, standardized systems for handling the mechanics of settlements has radically reduced risk, but when people make large deals or operate outside a conventional settlement system, risk can become a bigger concern. The potential benefits of the deal are weighed against the associated risks and people decide if they are willing to take those risks on, and if there are any steps available to mitigate the risks, such as asking the other party to consider working with an escrow agent.