Settlement risk

Settlement risk is the risk that you keep your side of a bargain and your counterparty does not. You pay the currency or deliver the asset you owe, and the amount you were promised in return never arrives. Because you can lose the entire principal rather than a change in its value, settlement risk is also called principal risk. It is one of the oldest and most concrete risks in finance.

The failure that named it

On 26 June 1974, German regulators forced the troubled Bankhaus Herstatt into liquidation. That day, several banks had already released Deutsche Mark payments to Herstatt in Frankfurt, expecting US dollars in return in New York. Herstatt was closed at 16:30 in Germany, which was 10:30 in New York. The dollar legs were never paid. The time-zone gap between the two currency legs turned an ordinary set of trades into a full loss of principal for the counterparties.

The episode gave the foreign-exchange form of settlement risk its name, Herstatt risk, and, in the words of the BIS, it eroded confidence in interbank relations and caused a freeze in money market lending. It is the reason the entire architecture of modern foreign-exchange settlement exists.

Why it persists

Fifty years on, the risk has not gone away. The BIS estimates that around $1.4 trillion of foreign-exchange turnover was still settled without protection on an average day in April 2025, roughly a tenth of the deliverable market on a gross bilateral basis. That figure has fallen from $2.2 trillion in April 2022, but a large share of daily settlement still happens with one leg exposed to the other.

The gap has a structural cause. Money and its instructions live in separate, siloed systems, and the two currency legs of a trade often settle in different places at different times. Whenever there is a delay between one leg completing and the other, principal is at risk in between.

How it is contained

Two mechanisms do the real work. Netting reduces the amount at stake by offsetting mutual obligations, but it mitigates the exposure rather than removing it. Payment-versus-payment settlement removes it, by making each leg conditional on the other so that neither completes unless both do. On programmable infrastructure, the same all-or-nothing logic is expressed as atomic settlement. The distinction between mitigating a risk and eliminating it is worth holding onto: a netted position is smaller, but only a linked settlement is safe.