The 27th of June 2024 marked 50 years since the collapse of German-based Herstatt Bank showed financial institutions the drastic consequences of unchecked settlement risk in foreign exchange markets. But half a century on, ‘Herstatt risk’ – otherwise known as FX settlement risk – appears to be rising for financial institutions.

Let’s briefly revisit what derailed Herstatt Bank all those years ago to grasp the threat to markets today. Essentially, the firm’s risky bets and mismanagement led to substantial losses forcing authorities to close the bank. The speculative US dollar transactions were taking place across different time zones, meaning that many of Herstatt’s counterparties paid in their side of the trade, but received nothing back from the German bank after the regulators shut the firm. Herstatt Bank’s inability to fulfil its payment obligations wreaked havoc across global financial markets, with counterparties out of pocket for the money they never received – a perfect encapsulation of FX settlement risk which coined the term ‘Herstatt risk’.

The crisis conveyed a clear lesson to markets: the longer one party must wait for the other to meet its obligations, the higher the risk of financial losses or disruptions – possibly with systemic ramifications. Thankfully, Herstatt bank had a small footprint at the time of its collapse. But the issue of FX settlement risk lingered unaddressed for decades until the establishment of widespread payment-versus-payment (PvP) mechanisms for exchanging currencies, a process which sees both sides of a trade simultaneously exchange the currency they owe.

PvP has drastically reduced the risk of settlement failure in global FX markets. These safeguards have largely proven effective in mitigating settlement risk in FX markets over recent years. It’s notable that during major market crises of the last 20 years, in particular the great financial crisis and the Covid-19 market disruption, markets have not witnessed a Herstattesque event.

Unlike with Herstatt bank, the current factors causing an elevated risk of settlement failure in currency markets are not risky bets and bank mismanagement. Instead, it is two powerful changes in market dynamics:

1. changes in regulations related to settlement timelines, i.e. T+1 settlement; and
2. an uptick in emerging market currency trading.

Settlement at risk
With US securities now trading on a T+1 settlement regime, asset managers, custodians and banks are grappling with the fallout in currencies. In the run-up to the go-live of T+1, much was made of the potential dangers of compressed settlement timeframes in currency markets. In the initial aftermath, we are yet to see the dangers born out in major incidents of FX settlement failure. However, the shortened cycle adds pressure on a system already at capacity.

T+1 arrived against an already deteriorating backdrop, with growing concern from the likes of the Bank for International Settlements that Herstatt risk is on the rise. It cites the growing share of trades that settle without PvP protection as one of the main factors behind the elevated risk of settlement failure, driven primarily by the increase in emerging market currency trading, typically not eligible for today’s PvP mechanisms.

In fact, at the end of 2022, financial institutions sent $2.2tn worth of currencies to counterparties every day without knowing for certain whether they’d get paid. This is according to BIS data which shows a concerning trend: in 2019, just $1.9tn of transactions settled without PvP protection, an amount that rose 15% in the following three years.

Avoiding another Herstatt
Whether for the inter-bank market, bank to client, or custodians supporting their asset manager clients, the two factors together increase the importance of new alternative PvP systems to add on to the current structures that facilitate safe settlement and netting in foreign exchange markets. This is especially true for the emerging market currency challenge.

Broadening the narrow spectrum of 18 currencies currently eligible for PvP settlement would be a good place to start in tackling rising FX settlement risk, helping to address the growth of emerging markets and the swell of volumes in these non-PvP-protected currencies. In particular for the Chinese Renminbi, which is climbing up the ranks of daily FX trading volumes.

Rapid advances in technology are also opening new ways for risk management across all stages of the trade lifecycle, and FX settlement should be no different. Peer-to-peer networks, distributed data applications and shared workflows make FX exposures fully traceable across entire networks, with atomic settlement providing the speed to conduct trades efficiently in times of market stress. Meanwhile, in normal market conditions, network services enable users to optimise liquidity management through the use of netting and payment orchestration, which in turn minimises funding requirements and costs, in addition to reducing settlement risk.

But as always, an industry-wide paradigm shift requires extensive collaboration among peers and competitors. This may seem a dubious prospect, but the alternative is to wait for an FX settlement failure to hit the headlines, hopefully in a less spectacular fashion than the Herstatt collapse of half a century ago. The latter must not be considered an option. After all, while history seldom repeats itself, it often rhymes.

To find out how OSTTRA can help mitigate bilateral FX settlement risk between participants, watch this brief explainer video or contact us using the form below.