Understanding Cross-Currency Settlement Risk: A Comprehensive Guide

What Is Cross-Currency Settlement Risk?

Cross-currency settlement risk is a type of settlement risk in which a party involved in a foreign exchange transaction sends the currency it has sold but does not receive the currency it has bought. In cross-currency settlement risk, the full amount of the currency purchased is at risk. This risk exists from the time that an irrevocable payment instruction has been made by the financial institution for the sale currency, to the time that the purchase currency has been received in the account of the institution or its agent.

Cross-currency settlement risk is also called Herstatt risk, after the small German bank whose failure in June 1974 highlighted this risk.

Key Takeaways

• Cross-currency settlement risk is the potential for losses from a foreign exchange transaction where one currency pair is delivered but the second is not.
• With forex trades occurring 24/7, the two legs of a currency transaction will usually not be settled simultaneously since for one side of the currency it may be daytime and the other the middle of the night.
• While losses from this do occur occasionally, the real risk is small for most cross-currency transactions.
• Cross-currency settlement risk is also called Herstatt risk, after the small German bank whose failure in June 1974 highlighted this risk.

Understanding Cross-Currency Settlement Risk

One reason that cross-currency settlement risk is a concern is simply due to the difference in time zones around the world. Foreign exchange trades are conducted globally around the clock and time differences mean that the two legs of a currency transaction will generally not be settled simultaneously.

As an example of cross-currency settlement risk, consider a U.S. bank that purchases 10 million euros in the spot market at the exchange rate of EUR 1 = USD 1.12. This means that at settlement, the U.S. bank will remit US$11.2 million and, in exchange, will receive 10 million euros from the counterparty to this trade. Cross-currency settlement risk will arise if the U.S. bank makes an irrevocable payment instruction for US$11.2 million a few hours before it receives the EUR10 million in its nostro account in full settlement of the trade.

Financial institutions manage their cross-currency settlement risk by having clear internal controls to actively identify exposure. In general, the real risk is small for most cross-currency transactions. However, if a bank is working with a smaller, less stable client, they may choose to hedge the exposure for the duration of the transaction.

Herstatt Bank and Cross-Currency Settlement Risk

Although a failure in a cross-currency transaction is a small risk, it can happen. On June 26, 1974, German bank Herstatt was unable to make foreign exchange payments to banks it had engaged in trades with that day. Herstatt had received Deutsche Mark but, due to lack of capital, the bank suspended all U.S. dollar payments. This left those banks that had paid Deutsche Mark without the dollars it was due. The German regulators were swift in their actions, withdrawing the banking license that day.

Whenever a financial institution or the global economy, on the whole, is under strain, worries about cross-currency settlement risks emerge. The 2007-2008 Global Financial Crisis and the Greek debt crisis raised concerns about cross-currency settlement risk. Given how economically damaging both incidents were in other ways, the concerns over currency settlement risk turned out to be comparatively overstated.