The risks that are associated with the settlement of foreign exchange (FX) transactions. The inability to settle or timely settle such transactions gives rise to specific risks which may include principal risk, replacement cost risk, liquidity risk, operational risk and legal risk.

Collectively these risks are called settlement-related risk, where one party to a foreign exchange trade pays out the currency it sold or is required to deliver but does not receive the currency it bought or is supposed to get. This is also called Herstatt risk – named after the German Herstatt bank that collapsed and went out of business in 1974 because of its unchecked FX trading risks – and it was the very reason for setting up the Basel Committee on Banking Supervision (BCBS) at the time.

By nature, settlement related risks are considered a tail risk, but have always shown a great tendency to increase and have a wider impact. As market players, entities are expected to ensure that all settlement-related risks are effectively managed and that its practices are consistent, or aligned with, those used for managing other counterparty exposures of similar size and duration.

Entities can control such risks by also reducing the principal risk as much as practicable by settling FX transactions through safer venues- e.g., financial market infrastrucutres (FMIs) that provide PVP arrangements. In case PVP settlement is not practicable, an entity can properly identify, measure, control and reduce the size and duration of its remaining principal risk. Moreover, in their assessment of their capital needs, entities need to consider all types of settlement-related risks and that sufficient capital is held against these potential exposures, as appropriate.

Other possible means for mitigation of these risk include the use of netting arrangements and collateral arrangements to reduce replacement cost risk. Full collateralization can be achieved for mark-to-market exposure through physically settling FX swaps and forwards with counterparties that are financial institutions and systemically important non-financial entities.