Background
Settlement risk, also known as “delivery risk” or “Herstatt risk,” refers to the risk that one party in a transaction will fail to deliver on its contractual obligations, either by delivering assets late or by defaulting entirely. This type of risk is prevalent in the financial industry, particularly in the trading of securities, derivatives, commodities, and foreign exchange.
Historical Context
The pivotal moment highlighting the significance of settlement risk occurred with the collapse of the German bank Herstatt in 1974. Due to time-zone differences, an American bank transferred a sum to Herstatt in exchange for Deutschmarks, but before the transaction was completed, Herstatt was declared insolvent. The event exposed the systemic risk settlement risk poses within financial markets.
Definitions and Concepts
- Settlement Risk: The risk of a delay or failure in the completion of a transaction that can cause financial losses. The critical elements are the two-dimensional aspect of both timing (delay) and completeness (failure).
- Counter-Party Risk: A segment of settlement risk which arises directly from the uncertainty about a counter party’s ability to fulfill its obligations.
Major Analytical Frameworks
Classical Economics
Classical economic theory, focusing on macroeconomic principles, did not explicitly address settlement risk as it predominantly revolves around issues like production, growth, and market equilibrium.
Neoclassical Economics
Similar to classical economics, neoclassical frameworks tend to focus more on market functions and individual rational agents, implying that settlement risks are a reflection of imperfect markets or mismatched information.
Keynesian Economics
Keynesian approaches consider risk and uncertainty more holistically within the economy, implying that settlement risks are just part of market frictions that disrupt efficient market clearing. Policies to diminish these risks could involve regulatory safety nets or guarantees.
Marxian Economics
Marxian economics would consider settlement risk as part of inherent systemic instability within capitalist markets, pointing out that defaults and failures to settle are manifestations of deeper contradictions and crises tendencies within capitalist systems.
Institutional Economics
From an institutional perspective, settlement risks emerge from the structure and function of financial markets and institutions. This approach emphasizes the role of regulations, policies, and monitoring to mitigate such risks.
Behavioral Economics
Behavioral economics would examine how cognitive biases, overconfidence, and misjudgments lead to an underestimation of settlement risk and might advocate for more transparency and better risk communication to mitigate these biases.
Post-Keynesian Economics
Post-Keynesians emphasize financial instability and would likely view settlement risk as inherent to financial markets’ speculative and volatile nature, supporting stricter controls and safeguards.
Austrian Economics
Austrian economics might interpret settlement risk as an outcome of institutional meddling and argue for less interference in the markets to naturally rebalance risks through voluntary contractual compliance.
Development Economics
Development economics sees settlement risk as a barrier to financial development, particularly in emerging markets where weaker legal and institutional frameworks may exacerbate such risks.
Monetarism
Monetarists would consider settlement risk relevant to the extent it affects monetary stability and influence mechanisms that can inflate or destabilize monetary policy.
Comparative Analysis
Comparing classical to institutional frameworks shows a shift from a theoretical to a more practical focus on mechanisms that can handle risks without unnecessary market disruptions. Conversely, comparing behavioral and post-Keyesian approaches elucidates the influence of human biases and the speculative nature as contributors to settlement risk.
Case Studies
- Herstatt Bank (1974): Demonstrates how the interconnectedness of international financial transactions can propagate risk.
- The 2008 Global Financial Crisis: Highlights settlement risk within the context of complex derivatives and credit default swap agreements failing en masse.
- Commodity Exchanges: Several exchanges incorporate clearinghouses to act as counter-parties to mitigate settlement risk.
Suggested Books for Further Studies
- “Manias, Panics, and Crashes” by Charles P. Kindleberger and Robert Z. Aliber
- “When Genius Failed: The Rise and Fall of Long-Term Capital Management” by Roger Lowenstein
- “Finance and the Good Society” by Robert J. Shiller
Related Terms with Definitions
- Counter-party risk: The risk that the other party in a transaction may not fulfill its part of the deal.
- Clearinghouse: An intermediary between buyers and sellers in financial markets to ensure the transactions’ copying and maturity.
- Systemic risk: The risk of the complete breakdown of an entire system, effecting integral participant’s financial activities.
- Credit risk: Risk that a borrower will default on any type of debt by failing to make required payments.
- Liquidity risk: The risk that an entity may not be able to meet short-term financial demands due to the inability to convert assets to cash rapidly
