Settlement risk is the possibility that one or more parties in a transaction will fail to deliver assets or payments as agreed upon at the settlement time. This risk can happen when one party has already delivered the agreed-upon asset or payment, but the counterparty either delays or defaults on their obligation, resulting in a financial loss for the party that fulfilled its part first.

Settlement risk is a form of counterparty risk and is also sometimes called delivery risk or Herstatt risk, referencing the 1974 failure of Bankhaus Herstatt, which led to significant losses for counterparties in the foreign exchange market. It most frequently arises in transactions such as securities trades or foreign exchange deals, where timing mismatches during settlement can expose both parties to potential losses if one side does not perform as required.

Key points:

• Principal risk is a particularly severe form of settlement risk, involving the full value of the exchanged asset or payment if one party defaults before settlement is complete.
• The risk can propagate through markets if initial failures cause secondary failures, leading to broader financial instability.

Settlement risk can be mitigated through mechanisms such as delivery versus payment (DVP) systems, where the asset and payment exchange occur only if both sides meet their obligations simultaneously.

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