Afwikkelingsrisico

What Is Afwikkelingsrisico?

Afwikkelingsrisico, often referred to as settlement risk, is the financial risk that one party in a financial transaction will deliver its side of the bargain, but the counterparty will fail to deliver on its obligation. This failure can occur due to various reasons, including insolvency, technical issues, or fraud, before the exchange of assets or payments is complete. Afwikkelingsrisico is a critical concern within financial risk management and the broader framework of market infrastructure, as it directly impacts the finality and integrity of transactions across various payment systems and asset classes.

The risk manifests in the period between when one party makes its delivery (e.g., pays funds or transfers securities) and when it receives the corresponding delivery from its counterparty. The exposure to loss is the full value of the asset or payment delivered if the other side defaults. Mitigating afwikkelingsrisico is crucial for maintaining stability and confidence among market participants.

History and Origin

The concept of afwikkelingsrisico, though inherent in any non-simultaneous exchange, gained significant attention in the mid-20th century, particularly after the collapse of Bankhaus Herstatt in 1974. On June 26, 1974, German authorities liquidated Herstatt Bank, a German financial institution heavily involved in foreign exchange (FX) trading. The bank's closure occurred after it had received payments in Deutsche Marks from its counterparties in Europe, but before those same counterparties had received their corresponding U.S. dollar payments in New York due to time zone differences²²,²¹,²⁰.

This event, widely known as "Herstatt Risk," highlighted the potential for substantial principal losses in cross-currency transactions if one party failed to meet its obligations¹⁹,¹⁸. The ripple effect of Herstatt’s failure underscored the interconnectedness of global financial markets and the potential for a single institution's default to trigger widespread disruption, leading to heightened awareness of systemic risk,.^{17 16}The incident served as a powerful catalyst for central banks and regulators worldwide to develop more robust and secure mechanisms for the settlement of financial transactions.
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Key Takeaways

• Afwikkelingsrisico is the risk of principal loss if one party delivers its side of a trade, but the counterparty fails to deliver theirs before settlement is complete.
• It is a significant concern in financial markets, especially for transactions involving different time zones or delayed settlement.
• The collapse of Herstatt Bank in 1974 prominently illustrated the dangers of afwikkelingsrisico, particularly in foreign exchange.
• Mitigation strategies include payment-versus-payment (PvP) systems, central counterparties, and real-time gross settlement.
• Effective management of afwikkelingsrisico is vital for the stability and integrity of global financial market infrastructures.

Interpreting the Afwikkelingsrisico

Interpreting afwikkelingsrisico primarily involves understanding the specific mechanisms put in place to manage it within a particular transaction or market. In systems where settlement is not immediate and simultaneous, the level of afwikkelingsrisico depends on factors such as the settlement cycle, the robustness of the post-trade processing infrastructure, and the creditworthiness of the counterparties involved.

For example, in many securities transactions, a delivery-versus-payment (DvP) mechanism is used, meaning that the transfer of securities only occurs if the corresponding payment is simultaneously made. This design significantly reduces afwikkelingsrisico by ensuring that neither party is exposed to the principal of the trade without receiving the other leg. Similarly, in foreign exchange, systems that ensure "payment-versus-payment" (PvP) eliminate the risk of principal loss by guaranteeing that the final transfer of one currency occurs only if the final transfer of the counter currency takes place.

Hypothetical Example

Consider two hypothetical banks, Alpha Bank and Beta Bank, agreeing to exchange €1 million for $1.1 million in a foreign exchange spot trade.

1. Agreement: On Monday morning, Alpha Bank agrees to sell €1,000,000 to Beta Bank and buy $1,100,000 from Beta Bank.
2. European Payment: Alpha Bank, located in Europe, sends its €1,000,000 payment to Beta Bank's European correspondent account. This payment is typically irrevocable and occurs during European business hours.
3. Time Zone Difference: Due to the time difference, New York's banking day (where the dollar payment would be received) has not yet fully begun.
4. Beta Bank Default: Before Beta Bank can send the $1,100,000 payment from its New York account, an unforeseen insolvency event occurs, and Beta Bank declares bankruptcy.
5. Afwikkelingsrisico Materializes: Alpha Bank has delivered its €1,000,000, but it will not receive the $1,100,000 it was owed. Alpha Bank is now exposed to the full principal amount of €1,000,000 because Beta Bank failed to complete its side of the transaction before settlement finalized. This situation represents the materialization of afwikkelingsrisico. If this transaction were processed through a system like Continuous Linked Settlement (CLS) Bank, the euro and dollar payments would be settled simultaneously, greatly reducing or eliminating this risk.

Practi¹⁴cal Applications

Afwikkelingsrisico is a key focus in the design and regulation of financial market infrastructures globally. Regulators and industry bodies have implemented various solutions to mitigate this type of risk, ensuring the smooth functioning of markets.

One significant development is the widespread adoption of real-time gross settlement (RTGS) systems for large-value payment systems. These systems ensure that individual payments are settled continuously and irrevocably on a gross basis, thereby eliminating afwikkelingsrisico by ensuring payment and receipt are simultaneous.

For securities transactions, the Depository Trust & Clearing Corporation (DTCC) in the U.S. provides central clearing house and settlement services that significantly reduce afwikkelingsrisico through netting and delivery-versus-payment mechanisms,,. Their pr¹³o¹²c¹¹esses involve the simultaneous transfer of securities and funds, typically on a T+2 (trade date plus two business days) or T+1 basi¹⁰s, meaning the actual exchange of ownership and payment happens concurrently.

In foreig⁹n exchange markets, the Continuous Linked Settlement (CLS) Bank was established to specifically address Herstatt Risk. CLS processes foreign exchange instructions on a payment-versus-payment (PvP) basis, guaranteeing that the payment in one currency occurs if and only if the corresponding payment in the other currency also occurs,. This effe⁸c⁷tively eliminates the principal risk associated with cross-currency settlement.

Furthermo⁶re, the Central Counterparty (CCP) model, particularly prominent in derivatives and some securities markets, also plays a crucial role. A CCP interposes itself between the original buyer and seller, becoming the buyer to every seller and the seller to every buyer. This novation process mutualizes and manages counterparty exposures, significantly reducing afwikkelingsrisico for direct market participants. The Principles for Financial Market Infrastructures (PFMI), issued jointly by the Bank for International Settlements (BIS) and the International Organization of Securities Commissions (IOSCO), provide international standards for the oversight and supervision of systemically important financial market infrastructures, directly addressing settlement risk management,,.

Limi⁵t⁴a³tions and Criticisms

Despite sophisticated mechanisms, complete elimination of afwikkelingsrisico can be challenging, and mitigation efforts come with their own set of considerations. For instance, while a Central Counterparty significantly reduces bilateral credit risk among its members, it concentrates this risk within the CCP itself. This makes the CCP a single point of failure, requiring robust default management procedures, liquidity risk management, and stringent capitalization.

Another l²imitation pertains to the scope of these mitigation systems. While CLS Bank covers a substantial portion of the global foreign exchange market, not all currency pairs or market participants utilize its services, leaving some transactions still exposed to bilateral afwikkelingsrisico. Similarly, the move to shorter settlement cycles, like T+1, reduces the time window for risk exposure but can introduce increased operational risk for participants who must process and affirm trades more quickly.

Moreover,¹ the costs associated with implementing and maintaining robust settlement systems and the infrastructure for custody can be substantial. These costs are ultimately borne by market participants through fees or operational investments, posing a challenge, particularly for smaller firms or less liquid markets. While progress has been made, residual afwikkelingsrisico can persist in highly complex or illiquid trades, or in situations where underlying legal frameworks across jurisdictions may not fully align.

Afwikkelingsrisico vs. Counterparty Risk

While often used interchangeably or confused, afwikkelingsrisico and counterparty risk are distinct concepts within financial risk.

In essence, afwikkelingsrisico is a specific type of counterparty risk that arises during the settlement phase of a transaction. While counterparty risk encompasses the broader possibility of a trading partner defaulting on any agreement, afwikkelingsrisico specifically concerns the principal loss incurred when one leg of a two-way transaction is completed, but the other fails to materialize before final settlement.

FAQs

What causes Afwikkelingsrisico?

Afwikkelingsrisico arises when the two sides of a financial transaction, such as a currency exchange or a securities trade, are not settled simultaneously. Causes include time zone differences, operational failures, technical glitches, or, most critically, the insolvency or default of one of the parties before they can complete their part of the exchange.

How is Afwikkelingsrisico different from Credit Risk?

Credit risk is the general risk that a borrower or counterparty will not meet their financial obligations. Afwikkelingsrisico is a specific manifestation of credit risk that occurs during the settlement process, where one party loses the full principal amount because the other party defaults after receiving their own payment or asset, but before delivering their side. It's a risk of principal loss during the brief window of settlement, whereas credit risk covers all potential defaults over the life of a contract.

What is Payment-versus-Payment (PvP)?

Payment-versus-Payment (PvP) is a mechanism designed to eliminate afwikkelingsrisico in foreign exchange transactions. It ensures that the final transfer of a payment in one currency occurs if, and only if, the final transfer of a payment in the counter-currency takes place. The CLS Bank, for instance, operates on a PvP basis to mitigate this risk across multiple currencies.

Is Afwikkelingsrisico still a concern today?

Yes, despite significant advancements in financial market infrastructure and risk mitigation techniques, afwikkelingsrisico remains a concern, particularly in cross-border transactions and emerging markets. Regulators and financial institutions continuously work to enhance settlement systems and processes to further reduce this risk and bolster financial stability. Changes in settlement cycle times, such as the move to T+1 for securities, aim to reduce exposure windows, but also introduce new operational risk challenges.