Settlement Risk

Settlement risk is the possibility that a counterparty will fail to deliver on the terms of a contract at the agreed-upon time. It is a form of counterparty credit risk that arises due to timing differences in the exchange of cash flow between two parties, often related to a foreign exchange forward contract with an actual exchange of two different currencies or currency cash flows (as opposed to net settlement in which only the difference in mark-to-market is paid by the party that is out of the money).

DIFFERENT TYPES OF SETTLEMENT GIVE RISE TO DIFFERENT RISKS

GROSS SETTLEMENT

If a transaction settles on a gross basis, each party must deliver the underlying asset and the gross amount of funds to the other party.

For example, let’s assume Party A agreed with Party B to sell Security XYZ a year from now for $100. At maturity, Party B will pay Party A $100, and Party A will deliver Security XYZ to Party B. If the market value of Security XYZ increases to $120 over the next year, Party B will still only pay $100 for that security. If Party A owns the security, it could have sold it outright for $120 but is now obliged to sell it at a below-market price of $100. If Party A does not own the asset, it will have to source it in the market for $120 and then sell it to Party A for $100. Regardless, Party A will effectively lose $20 on the transaction, while Party B will gain $20 (i.e., $120--$100).

In the example above, Party B would be required to pay $100 to Party A. Party A would need to deliver the security worth $120 to Party B. The “net” transaction value, i.e., the gain or loss depending on the party, is only $20. However, the settlement risk amounts to the total gross amount of $120. If Party B pays $100 but doesn’t receive the security, it risks losing $100 of the delivered cash plus the $20 gain it is owed. If Party A delivers the security worth $120 but doesn’t receive the cash, it has lost an asset worth $120.

The counterparty credit risk involved in financial markets can be significant. Taking the same example as above, Party B – counting on the Security XYZ to be delivered at the maturity or settlement date – may have agreed with a third-party, Party C, to sell the same Security XYZ for $105. However, suppose Party A fails to deliver it to Party B at maturity. In that case, Party B may fail to deliver it to Party C. So the initial failure by Party A towards Party B will result in a failure by Party B towards C, and so on.

DELIVERY VS. PAYMENT SETTLEMENT

Most securities transactions today are settled “delivery versus payment” (DVP). DVP means that the assets to be exchanged are only delivered if the funds are paid.