Herstatt risk: Meaning, Criticisms & Real-World Uses

What Is Herstatt Risk?

Herstatt risk refers to a specific type of settlement risk that arises in international foreign exchange transactions due to timing differences between payment systems in different countries. It is the risk that one party to a currency exchange transaction pays the currency it owes but does not receive the currency it is owed, typically because the counterparty defaults or becomes insolvent during the settlement lag. This exposure represents a potential loss of the full principal amount of the transaction. Herstatt risk is a critical concern within financial risk management, particularly in global markets where cross-border payments involve multiple time zones and distinct national clearing systems.

History and Origin

Herstatt risk is named after the failure of Bank Herstatt, a privately owned German bank that collapsed on June 26, 1974. The bank had accumulated significant losses from speculative foreign exchange trading. On that day, German regulators withdrew Bank Herstatt's banking license and forced its liquidation at the end of the German business day. Due to the time zone difference, this occurred while the U.S. financial markets were still open. As a result, many banks that had paid Deutsche Marks to Herstatt in Frankfurt did not receive their corresponding U.S. dollar payments in New York before Herstatt ceased operations. This left numerous banks with substantial losses, highlighting a major vulnerability in the international payment system.¹⁹,¹⁸,

The Herstatt Bank failure sent shockwaves through the international financial system, leading to a significant disruption in interbank foreign exchange markets as banks became hesitant to conduct transactions without assured simultaneous settlement. This event served as a catalyst for global central banks and regulators to address foreign exchange settlement exposures, prompting the formation of the Basel Committee on Banking Supervision later that year.,

Key Takeaways

Herstatt risk is a form of settlement risk in foreign exchange transactions.
It arises from the time lag between the payment of one currency and the receipt of another in cross-border deals.
The risk gained prominence after the 1974 failure of Bank Herstatt.
It exposes transacting parties to the potential loss of the full principal amount of the transaction.
Measures like payment versus payment (PvP) systems and real-time gross settlement (RTGS) were developed to mitigate Herstatt risk.

Interpreting Herstatt Risk

Herstatt risk is a qualitative measure of potential exposure rather than a quantitative one. It signifies the presence of principal risk in foreign exchange transactions due to asynchronous settlement. If a transaction is subject to Herstatt risk, it means that one leg of the trade could be completed, while the other fails due to the counterparty risk of the defaulting entity. Banks and financial institutions interpret the existence of Herstatt risk as an unmitigated exposure to complete loss on a foreign exchange trade. Their goal is to identify and eliminate this risk wherever possible through robust settlement mechanisms and operational controls.

Hypothetical Example

Consider a hypothetical scenario involving two banks, Alpha Bank in New York and Beta Bank in London, agreeing to an exchange of 10 million USD for 8 million GBP.

Agreement: Alpha Bank agrees to pay 10 million USD to Beta Bank, and Beta Bank agrees to pay 8 million GBP to Alpha Bank. The transaction is set to settle on the same day.
Time Zone Difference: Due to time zone differences, the payment systems operate at different hours. London's payment system closes several hours before New York's.
Payment by Beta Bank: Beta Bank, operating in London, initiates and successfully sends the 8 million GBP to Alpha Bank's account in London during its business day.
Default by Alpha Bank: Before Alpha Bank can send the 10 million USD from its New York account, perhaps due to an unexpected financial crisis or operational failure that leads to its insolvency, its payment system effectively shuts down.
Herstatt Risk Realized: Alpha Bank has received the GBP, but Beta Bank has not received the USD. Beta Bank has effectively paid its part of the trade but faces the loss of the entire 10 million USD, as Alpha Bank has defaulted. This illustrates Herstatt risk in action, where the payment in one currency is completed, but the corresponding payment in the other currency fails, leaving the paying party exposed to the full principal risk.

Practical Applications

Herstatt risk is a foundational concept in discussions surrounding modern payment systems and global banking regulation. Its practical applications are primarily seen in:

Foreign Exchange Market Infrastructure: The failure of Bank Herstatt was a major impetus for the development of the Continuous Linked Settlement (CLS) system. CLS Bank, which became operational in 2002, significantly mitigates Herstatt risk by settling foreign exchange transactions on a payment versus payment (PvP) basis. This means both legs of a currency transaction are settled simultaneously and irrevocably, ensuring that a transfer in one currency occurs only if the transfer in the other currency also occurs.,¹⁷,¹⁶ CLS handles a substantial portion of global foreign exchange turnover, drastically reducing the exposure to settlement risk for its members.¹⁵
Regulatory Frameworks: The incident directly led to the establishment of the Basel Committee on Banking Supervision, which subsequently issued guidance and standards for managing settlement risk in foreign exchange transactions.¹⁴,,¹³ These guidelines emphasize the need for robust risk management processes, including the measurement and control of exposures.¹²
Risk Management in Financial Institutions: Banks engaged in foreign exchange trading actively implement strategies to manage Herstatt risk. This includes using systems like CLS, establishing strict credit risk limits for counterparties, and employing netting arrangements to reduce gross exposures. Firms assess operational risk and liquidity risk related to payment processes to prevent scenarios where Herstatt risk could materialize.

Limitations and Criticisms

While the development of systems like CLS has significantly reduced Herstatt risk, it has not been entirely eliminated. A limitation is that not all currencies or market participants are part of PvP settlement systems like CLS.¹¹,¹⁰ Emerging market currencies, for example, may have less access to these risk mitigation alternatives, leaving a portion of foreign exchange turnover still exposed to settlement risk.⁹,⁸

Furthermore, relying on a single, large-scale settlement utility like CLS, while highly effective, can introduce a degree of systemic risk if that system itself were to face a major disruption. Regulators and central banks continuously monitor such critical financial market infrastructures to ensure their resilience. Critiques also sometimes point to the cost and complexity for smaller institutions to gain direct access to these advanced settlement systems, forcing them to rely on correspondent banking relationships which may still carry some residual Herstatt risk.

Herstatt Risk vs. Settlement Risk

Herstatt risk is a specific form of settlement risk, but the terms are often used interchangeably in the context of foreign exchange. Settlement risk is the broader concept, defined as the general risk that one party to a financial transaction fails to deliver on their obligations at the agreed-upon time, even after the other party has performed. This can apply to securities, commodities, or currency transactions.

Herstatt risk specifically refers to settlement risk in foreign exchange transactions that arises due to the time difference between the settlement of the two currency legs of a trade. This temporal mismatch creates a window where one party has delivered its payment, but has not yet received its counter-payment, thus being fully exposed to the defaulting counterparty for the entire principal amount. Therefore, while all Herstatt risk is settlement risk, not all settlement risk is Herstatt risk, as settlement risk can encompass other issues like delays, errors, or default in non-time-zone-dependent transactions.

FAQs

What caused Herstatt risk to be identified?

Herstatt risk was identified after the failure of Bank Herstatt in 1974. Due to time zone differences, the bank was liquidated after it had received Deutsche Mark payments from counterparties but before it could deliver the corresponding U.S. dollar payments, leaving other banks with significant losses.⁷,

How is Herstatt risk mitigated today?

The primary method for mitigating Herstatt risk today is through payment versus payment (PvP) settlement systems, most notably the Continuous Linked Settlement (CLS) system. PvP ensures that both sides of a foreign exchange transaction are settled simultaneously, preventing one payment from occurring without the other.,⁶,⁵

Is Herstatt risk still a concern?

While systems like CLS have greatly reduced Herstatt risk for many major currency pairs and participants, it has not been entirely eliminated. It remains a concern for transactions involving currencies or parties not utilizing PvP mechanisms, or in less standardized foreign exchange deals.⁴,³

What role do central banks play in addressing Herstatt risk?

Central banks played a crucial role in responding to the Herstatt Bank failure by promoting international cooperation and the development of safer payment systems. They oversee and regulate systems like CLS and issue guidelines, often through bodies like the Basel Committee on Banking Supervision, to ensure financial institutions manage foreign exchange settlement risk effectively.²,,¹