Traders face daily risks that go far beyond ordinary price fluctuations. In fact, some threats are almost invisible but potentially much more harmful. One of these dangers is
Herstatt risk, a phenomenon that emerged in the 1970s and is still relevant today.
We will discuss it in this article. We will explain what it is, where it originates from, and how it is possible to prevent the most serious consequences, especially in the retail sphere.
What is Herstatt risk
Herstatt risk is named after
Herstatt Bank, a German bank based in Cologne that suddenly collapsed in June 1974. That day, some international operators had already transferred US dollar funds to the German bank, awaiting
settlement in Deutsche marks scheduled for a few hours later.
However, the revocation of the bank's license by the Bundesbank occurred between the two settlement moments. As a result,
the dollar funds had already been transferred, but those in marks were never received.
This event highlighted a problem that had been underestimated until then:
the risk of temporal settlement in forex operations, especially when involving different time zones.
The phenomenon occurs when the currencies being exchanged are settled at different times, leaving a time window during which one party has already fulfilled its obligations, while the other may never do so due to
default, operational problems, or unforeseen events.
In technical language, this is also called
settlement risk.
Herstatt risk is characterized by some peculiar elements.
- It is timing-related: it concerns the interval between the payment made by one party and the receipt of payment by the opposite party.
- It affects cross-currency forex transactions, particularly when the currencies are settled in jurisdictions with different time zones (e.g., USD/JPY, EUR/USD).
- It implies a credit exposure even if formally it is not a credit but an exchange.
What happens if Herstatt risk becomes a reality
When
Herstatt risk materializes, the consequences can be significant for both counterparties involved and, in extreme cases, for the stability of the entire financial system.
- Immediate loss of transferred capital. The most direct effect is the total or partial loss of the amount already sent. If the counterparty fails or is subject to an operational block before making the payment in the opposite currency, the transfer will never be completed.
- Impact on related positions. Often, FX operations are part of more complex strategies: hedging, arbitrage, carry trade, etc. If a payment is not settled, the entire operational structure collapses, causing further losses and risk misalignments.
- Domino effect in the financial system. In the case of Herstatt Bank, the failure to receive currency by some foreign banks created imbalances in daily balance sheets, generating interbank tensions and reducing mutual trust. This event was one of the precursors to the birth of centralized settlement initiatives such as CLS Bank.
- Increase in perceived risk in the forex market. When a case of Herstatt risk occurs, even if isolated, confidence in the foreign exchange market may decrease, leading to requests for higher guarantees, widened spreads, and reduced liquidity. All of this indirectly penalizes retail traders as well.
- Legal and reputational risk. Finally, banks or counterparties involved in a Herstatt risk default may suffer legal damages, international disputes, and a strong impact on reputation, with long-term consequences.
How to protect yourself
Protection from Herstatt risk requires
careful management of the settlement process, both from a technical and contractual point of view. Here are the best practices.
Use of CLS Bank
CLS (Continuous Linked Settlement) is a global platform created precisely to solve the Herstatt risk problem. It works through a
payment-versus-payment (PvP) mechanism that ensures that
the two currencies are settled simultaneously or not at all.
Operating through CLS, the world's leading banks securely settle their FX operations,
drastically reducing the risk of counterparty default at the moment of exchange.
However,
CLS is only accessible to authorized operators of large size. Retail brokers, for example, do not access it directly but can use prime banks that make use of it.
Active management of settlement time windows
In the absence of CLS, counterparties can reduce risk by adopting
specific agreements on payment timing.
For example:
- Avoid FX operations with deferred settlement between very distant time zones (e.g., Asia and USA).
- Agree on clauses that provide for simultaneous receipt through correspondent banks.
- Use rigorous and automated cut-off times to better synchronize flows.
These strategies do not eliminate risk but
contain it within predictable margins.
Diversification of counterparties
Those who operate in Forex through multiple brokers, banks, or liquidity providers can
reduce potential exposure concentrated on a single counterparty. In case of operational problems or default, the overall damage is lower compared to a single exposure.
Even in retail trading, where Herstatt risk is secondary, it is good practice to
choose well-regulated intermediaries, possibly with a multi-bank structure and top-tier partners.
Monitoring news on banks and systemic institutions
Herstatt risk can arise suddenly, but it is often
preceded by signals: banking crises, rating cuts, regulatory investigations, problematic mergers. Keeping an eye on macro and financial news can help
avoid maintaining open positions during phases of market instability.
