Foreign Exchange Settlement Risk

B

In order to minimize credit risk, most banks will transact large amounts only with blue chip customers.

The correct answer to the question is B. Settlement (Herstatt) risk.

Settlement risk refers to the risk that a bank or financial institution may not receive the expected funds or assets in a financial transaction, particularly in the context of foreign exchange deals. It is also known as Herstatt risk, named after a famous case involving the German bank Herstatt in 1974.

In a foreign exchange deal, two parties agree to exchange currencies at an agreed-upon exchange rate. The settlement process involves the actual transfer of funds or assets between the parties involved. Settlement risk arises when one party fulfills its obligation by delivering the currency it has agreed to exchange, but the counterparty fails to deliver the agreed-upon funds in return.

This type of risk is particularly prevalent in foreign exchange transactions because they involve the simultaneous exchange of currencies across different time zones. Due to time zone differences, one party may have already fulfilled its obligation by delivering the currency, while the counterparty's obligation is yet to be met. If the counterparty fails to deliver the funds, the bank that has already delivered the currency will be left exposed and may incur significant losses.

The term "Herstatt risk" originates from the case of Bankhaus Herstatt, a German bank that collapsed in 1974. The bank had received payments in Deutsche Marks from its counterparties in various foreign exchange transactions but failed to deliver the corresponding payments in other currencies. As a result, many counterparties suffered significant losses.

To mitigate settlement risk, banks and financial institutions employ various measures. One common approach is to use payment systems that ensure the simultaneous exchange of currencies, such as Continuous Linked Settlement (CLS) system. Additionally, netting arrangements, where multiple obligations are consolidated into a single payment, can reduce the number of transactions and associated risks.

In summary, settlement risk, or Herstatt risk, is the risk that a bank will deliver currency on one side of a foreign exchange deal while the counterparty fails to send any money in return. It is an important consideration in foreign exchange transactions and is mitigated through the use of payment systems and netting arrangements.