Herstatt Risk

Herstatt Risk (also known as 'cross-currency settlement risk' or simply 'settlement risk') is a specific type of risk associated with foreign exchange transactions. It's the danger that one party in a currency trade delivers the currency it sold but never receives the currency it bought from the other party. This isn't just a simple case of a counterparty being dishonest; it's a structural risk born from the simple fact that our world has different time zones. Because global banks operate in different parts of the world, their payments are often processed at different times. Herstatt risk is the financial black hole that can open up in those hours between “payment sent” and “payment received.” If one bank collapses during this gap, the other is left holding an empty bag, having paid out millions with nothing in return. It’s a high-stakes game of tag where one player can be declared “out” mid-game, leaving the other with a massive, unexpected loss.

The risk gets its dramatic name from a real-life financial drama that unfolded on June 26, 1974. The main character was Bankhaus Herstatt, a mid-sized German bank heavily involved in currency speculation. On that fateful day, German financial regulators, having discovered the bank was insolvent, made a critical decision: they revoked its banking license and ordered it to be liquidated. There was just one problem: they did it at 4:30 PM German time. While Germany was closing up shop for the day, the foreign exchange market in New York was still in full swing. Throughout the morning, Herstatt's counterparties in the US had been dutifully sending payments in Deutsche Marks to the bank in Germany, fully expecting to receive their corresponding US Dollars later in the US business day. But when the German regulators shut Herstatt down, all outgoing payments were frozen. The US dollars were never sent. This left numerous banks, primarily in New York, having fulfilled their side of the bargain but receiving nothing in return, triggering a chain reaction of losses and a crisis of confidence that seized the global financial system.

Let's break it down with a simple example. Imagine a value investor's favorite European car company, “EuroAuto,” wants to pay its American supplier, “US-Steel.” This requires a currency exchange.

• The Trade: EuroAuto’s bank in Frankfurt (Bank F) agrees to sell €10 million to US-Steel’s bank in New York (Bank NY) in exchange for the equivalent amount in US dollars.
• Payment Leg 1 (The Euro): At 10:00 AM Frankfurt time, Bank F sends the €10 million to Bank NY. The payment arrives and is confirmed. So far, so good.
• The Time Gap: New York is 6 hours behind Frankfurt. It's only 4:00 AM there. Bank NY won't process its outgoing US dollar payment for several more hours.
• The Risk Window: This multi-hour gap is where Herstatt risk lives. During this window, Bank F is exposed. It has paid out the euros but has not yet received the dollars.
• The Disaster Scenario: If Bank NY were to suddenly declare bankruptcy at 8:00 AM New York time (before sending the dollars), Bank F would be out €10 million. The money is gone, and nothing is coming back.

“I'm not a global bank,” you might say, “so why should I care?” You should care because Herstatt risk is a classic example of systemic risk—the danger that the failure of one financial institution can trigger a cascade of failures throughout the entire system. Even if you only own stocks in solid, well-managed companies, a major banking collapse caused by settlement failures can freeze credit markets, tank stock market sentiment, and plunge the economy into a recession. Your portfolio is part of this financial ecosystem. For a value investor, understanding risks like this is crucial. It's a reminder that a company's fundamental value can be sideswiped by external, system-level shocks. The stability of the banking system that facilitates global trade and investment is a foundational assumption for all investors, and Herstatt risk is a direct threat to that stability.

Fortunately, the 1974 Herstatt crisis was a massive wake-up call. It spurred the creation of systems designed to eliminate this specific risk. The primary solution is a concept called Payment versus Payment (PvP). A PvP system ensures that the final transfer of one currency occurs if and only if the final transfer of the other currency also occurs. The most important of these systems is the Continuous Linked Settlement (CLS) Bank, established in 2002. CLS acts as a trusted global middleman for the world's largest banks. When two CLS members trade currencies, both send their payments to CLS. CLS holds onto both payments and only releases them to their final recipients simultaneously. If one party fails to pay, the other party's payment is returned, and no loss occurs. This transforms a risky two-step process into a single, risk-free transaction. While CLS has dramatically reduced Herstatt risk for trades between its members in major currencies, the risk has not been completely eliminated. It still exists for currencies not settled through CLS and for trades involving non-member banks, particularly in emerging markets.