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Settlement risk is the risk that arises when payments are not exchanged simultaneously. The simplest case is when a bank makes a payment to a counterparty but will not be recompensed until some time later; the risk is that the counterparty may default before making the counterpayment.
Settlement risk is most pronounced in the foreign exchange markets, where payments in different currencies take place during normal business hours in their respective countries and can therefore be made up to 18 hours apart, and where the volume of payments makes it impossible to monitor receipts except on a delayed basis.
This type of risk afflicted counterparties of Germany’s Bank Herstatt in 1974, which closed its doors between receipt and payment on foreign exchange contracts. As a result, settlement risk is sometimes called Herstatt risk.
See also Settlement.
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