Herstatt, 1974Needs one idea

A bank closed between the two legs of a currency trade. The counterparties had paid and had not been paid, and settlement risk acquired a surname.

3 min read · 562 words

What happened

• The trade — a spot currency deal has two legs. One party pays currency A, the other pays currency B. They settle in two different countries, through two different payment systems, which are open at different hours.
• 26 June 1974 — the German banking authority withdrew the licence of Bankhaus Herstatt, a Cologne bank, and ordered it into liquidation during the afternoon, German time.
• The timing — by then, counterparties had already paid Deutsche Marks into Herstatt that day through the German system. The corresponding dollar payments were due later, through New York, which had barely opened.
• The result — the German payments were made and the dollar payments were not. Counterparties had performed their side of trades whose other side no longer existed.
• Afterwards — the episode is the reason the Basel Committee on Banking Supervision was set up later that year, and the reason the industry eventually built CLS, a settlement system that went live in 2002 and pays both legs or neither.

The mechanism

• The exposure is not market risk. Nothing about exchange rates caused this. The loss was the full principal of one leg, and it happened to parties whose trades were profitable.
• Time zones are a credit exposure. Between paying and being paid, a counterparty holds an unsecured claim for the whole amount. The gap can be hours; it was never priced as if it were a loan, which is exactly what it is.
• Netting does not help across the moment. Two parties can agree to net a hundred trades into one payment and still face the same problem on that one payment: somebody pays first.
• The fix is structural, not contractual. Payment-versus-payment — the two legs released together or not at all — removes the exposure rather than allocating it. That is what clearing and settlement is for, and why the plumbing is a subject rather than a detail.

What it teaches

• A completed trade is not a settled trade. The economics were agreed; the money had not finished moving. Most instruments on this site have a gap between those two moments, and each category page says how long it is.
• The largest exposures are often the least discussed. Settlement exposure is the notional, not the profit and loss — and it existed on the books of institutions that would have described their currency risk as hedged.
• Infrastructure is a response to a specific failure. CLS exists because of a date. So do circuit breakers, central clearing mandates and daily variation margin. The plumbing is a museum of things that went wrong once.
• Operational risk decides more instruments than people expect. This is the earliest case on the site where nothing was mispriced and everything was lost. See which risk decides.

The mechanisms behind this

• Clearing and settlement — what happens after the price is agreed, and why it takes time.
• FX spot — the instrument, and the two legs that made this possible.
• Which risk decides — operational and settlement failure as a category of its own.