Settlement Risk: Understanding How To Deal With It

Key Takeaways: 
 

• Settlement risk is a type of risk that occurs during a deal when one party pays the amount but does not receive what was promised in return. 
   
• Most people get confused about “Is settlement risk a credit risk?” The answer is yes. Both of them are mostly similar in nature. 
   
• This type of risk is often seen during foreign exchange transactions because of time zone differences. 

Most people, especially in India, have experienced different types of fraud related to online shopping and deliveries. One of the most common ones is when you order something from a website, and it asks you to make the payment in advance. Deep down, you know it is a fraud, and the product will never arrive, but still, you pay the full amount. And guess what happens next? You never received the product, and you can not make any complaints because it was your decision after all. 

A very similar thing is seen in the financial markets. When two parties make a deal, one pays the full amount in advance but never receives what was promised by the other party. It often happens when one side fails or delays fulfilling their part of the deal. But the blame will be on the party that paid in the first place, right? 

This risk is not very rare, and it's not like only you are dealing with it; there are many people who can claim to experience the same thing. This risk is mostly seen in the foreign exchange market, the reason for this is the time zone difference. Let’s take a deeper look into it and understand how this happens and how you can deal with it. 

Understanding What is Settlement Risk? 

If you search for settlement risk on Google, you will mostly see technical definitions and terms that normal people may find difficult to understand. Don’t worry, we have curated the easiest way for you to understand this term. 

In simple words, a settlement risk is the risk that one party faces during an online deal done in the exchange market. This happens when two parties finalise a deal, and one party agrees to pay money in advance in promise of receiving assets or services in return. But the thing that happens here is, they never receive the service or even their money back. Most people ask is settlement a credit risk; the answer is yes, both of these terms are very similar in various situations. 

This type of risk, or we can say fraud, is often seen specifically in foreign exchange markets. The settlement risk in foreign exchange is generally due to time zone differences between the two parties. 

Basically, this is what happens here: you transfer the money in return for assets, shares, or other services. However, the other party fails to complete their part of the deal. This gap between the two parties is what we call a settlement risk. 

Bonus Tip: Settlement risk is also known as Herstatt risk, which was renowned after the 1974 Bankhaus Herstatt collapsed. This event created the Basel Committee on Banking Supervision, setting global banking rules and capital standards.

Difference Between Pre-Settlement Risk Vs Settlement Risk

As we have already learned much about settlement risk, our main focus here will be to understand what pre-settlement risk is. 

Basically, a pre-sttlement risk or replacement risk is very similar to settlement risks. But, in the pre-settlement, the other party defaults a long time before the settlement due date. Meaning the deal is still in process, but suddenly the other party backs out. This leads to creating pressure on the second party to get engaged in a new contract, which may not be as favourable as the previous one. 

Below, we have mentioned a table through which you can check how settlement and pre-settlement risk are different from each other:

Hopefully, now you have understood the difference between the two of them. This can feel a bit tricky at first, but once you try to understand, it will be much easier. 

A very fun fact about pre-settlement risk is that it is very similar to the counterparty risk. This means that the difference between settlement risk vs counterparty risk is the same as mentioned above in the table. Most people get confused between these two terms, but they are the same. If you want to understand the difference between settlement risk vs counterparty risk, you can refer to the table above. 

Types of Settlement Risks

We all know how every situation has its own solution, and not one solution is made for every problem. Similarly, to deal with the different settlement risk, we have two important types of risk to deal with problems in the financial market. 

1. Default Risk: 

Default risk is seen when one party completely fails to complete or fulfill the contract and does not deliver the assets the other party asked for. This is one of the worst-case scenarios as the transaction does not happen at all. Default risk occurs when a company goes completely bankrupt or faces some serious financial issues. 

2. Settlement Timing Risk 

As the name suggests, this type of risk is often seen when the due date is near. Here, the transaction does happen, but not on time. Both parties complete the deal, but a slight delay in payment or delivering the assets can be seen. This can create uncertainty and even short-term loss for some. 

Here is a quick comparison between the two: