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Understanding Settlement Risk

Understanding Settlement Risk

As the name shows, a settlement risk is when one of the parties involved in a financial settlement, fails to abide by the contract terms at the time of the signing of the settlement. It is, in essence, the risk of default of payment when the settlement is done. The problem with this is that it can jeopardize the principle. As such, there are many financial services solutions that specialize in risk settlement.

There is also a timing issue in all of this. A prime example would be foreign exchange or forex trading, where timing is highly crucial. Another name for settlement risk is “Herstatt risk” which is a term coined after the failure of a German bank named Herstatt. In this situation, some banks had given Herstatt Deutschmarks in return for Dollars that was supposed to be given to a bank in New York. However, Herstatt closed down permanently before the funds were transferred to New York. This was due to the fact of time differences between the two countries. After that, the name stuck and the words “Herstatt Risk” has become synonymous with settlement risk.

What is a Settlement Period?

As mentioned, the settlement period is crucial in any transaction that faces settlement risk. Settlement period is defined as the time between the date of settlement and the date of a transaction. This time frame is put there to give the necessary parties enough time to fulfill their obligations. Both parties, in this case, are facing a risk. This is because the one who is buying needs to make the payment during the allotted time and the one who is selling, must make goods and services available during this time as well. There are allotted times that must be complied with for each type of transaction. For example, CD’s or Certificate of Deposits, transactions should happen on the same day itself. Forex transactions are given two days and so on. The key here is to have no doubts regarding the settlement period, and everything should go well.

Snail Mail and the Internet

Most of the rules regarding settlement period were written in a time before the internet existed. Therefore, the rules kept in mind the time it takes for the postal system to deliver the mail. This is why a generous amount of time was given for the settlement period. Nowadays, transactions can happen in a matter of seconds because of the internet. However, the rules regarding settlement period have not changed. Does this all mean that there are is no governmental organization looking over matters? The simple answer is no. The DTCC or the Depository Trust and Clearing Corporation has set up what is known as the NSCC (National Securities Clearing Corporation) which is a subsidiary to help protect everyone involved from settlement risk. The NSCC will keep everyone posted on the details of the transaction by confirming the settlement process. There have been various proposals of shortening settlement periods, but as of now, these have not gone into effect. However, it is never a bad idea to check with the broker, banker etc. just to be sure.


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