Herstatt risk

Herstatt risk is the settlement world’s proper noun: a category of risk named after a single afternoon. It denotes the exposure in any foreign exchange trade settled as two separate payments, where a party can pay away the currency it sold and, before receiving the currency it bought, watch its counterparty fail. What is lost is principal, the full value of the trade, which distinguishes it from the smaller costs of delay or replacing a trade at a worse price.

The afternoon in question

Bankhaus Herstatt was a mid-sized Cologne bank that had speculated heavily, and badly, in currency markets. On 26 June 1974 the German supervisor withdrew its licence and forced it into liquidation at 16:30 local time. The hour mattered more than the bank. It was 10:30 in New York: German banking hours were over, American ones had barely begun. Counterparties had paid Deutsche marks into Herstatt in Frankfurt that morning against dollars due in New York that afternoon. Herstatt’s US correspondent suspended payments from the account, and the marks were gone while the dollars never came. Exposures on the failed settlements were estimated around $200 million, and the shock rippled through interbank payment systems well beyond the direct counterparties.

The regulatory afterlife of that afternoon was substantial: before 1974 was out, the G10 central bank governors had created the committee that became the Basel Committee on Banking Supervision.

The structure of the risk

Herstatt risk is a time-zone problem before it is a credit problem. Two currencies settle in two national payment systems that open and close on different clocks, so one leg almost always achieves settlement finality before the other. The gap can stretch for hours, and a failure inside the gap converts a market relationship into a total loss of principal. Every hour a paid leg waits for its counterpart is settlement risk in its purest form.

The cure is structural too: bind the legs together so neither settles alone. Payment versus payment does exactly that, and CLS has operated it at scale since 2002 for 18 major currencies. But the umbrella has edges, and outside them the 1974 mechanics are intact. The BIS estimated in 2022 that around $2.2 trillion of daily deliverable FX turnover settled without PvP protection, concentrated in the emerging-market currencies that CLS does not cover. Herstatt risk earned its name half a century ago; it has not yet earned retirement.