The Biggest Risk in Foreign Currency Trading

Answering the Main Question

To answer the main question directly: what is considered the greatest risk associated with forex settlement is clearly settlement risk. This is the risk that a bank delivers the currency it sold in a foreign exchange deal but doesn't receive the currency it bought from the other party. It's also called principal risk, and for historical reasons, Herstatt risk.

The Clear Answer

Settlement risk is called the “greatest” for a simple and serious reason: it can cause a party to lose the entire amount of money in the transaction. Unlike market risk, where your investment might lose some value, settlement risk means the money you paid might never come back at all. Think of it like paying for a car and sending the full payment, only for the seller to disappear before giving you the keys. Your money is gone, and you have nothing. That's what principal risk means in the foreign exchange market. This chance of losing 100% of a trade's value is what makes it different from all other financial risks. The term Herstatt Risk, which means the same thing as settlement risk, comes from a disaster in 1974 that shows us exactly what can go wrong. We'll look at this story in detail.

Understanding Settlement Risk

To understand why settlement risk is such a big threat, you need to know how foreign exchange trades have traditionally worked. The danger doesn't come from bad intentions but is built into how global finance works across different countries and time zones. The main problem is that payments don't happen at the same time.

The Time Zone Problem

When two parties agree to trade currencies, for example, Euros (EUR) for Japanese Yen (JPY), the two payments don't happen together. Each currency payment goes through its own country's payment system. The EUR payment goes through a European system like TARGET2 during European business hours, while the JPY payment goes through Japan's BOJ-NET system during Japanese business hours.

This creates a big time gap. The party selling EUR will tell its bank to make the payment. Once that payment is made and final, there are several hours before the Japanese payment system opens and the JPY payment can be made. During this time, the party that paid the EUR is completely at risk. They've done their part but haven't received the JPY they're owed yet. If the other party fails for any reason during this gap—bankruptcy, government action, or major problems—the JPY payment would never happen. The first party would lose all their money.

This process uses a network of banks that hold accounts for each other, called Nostro and Vostro accounts. When a bank pays EUR, it tells its partner bank in Europe to take money from its EUR account and put it in the other party's account. This happens on one side of the world, expecting the reverse to happen hours later for the other currency. The following table shows this dangerous gap for a typical USD for JPY trade.

Principal vs. Other Risks

It's important to understand how principal risk is different from other common forex risks. Market risk is the danger that the USD/JPY exchange rate moves against you while you hold a position. You might lose 1% or 2% of the trade's value. Credit risk, before settlement, is the risk that your trading partner goes bankrupt before the settlement date, forcing you to make a new trade at a possibly worse rate. The loss is the difference in rates, not the full amount.

With settlement risk, the loss isn't a percentage; it's losing everything you put into that specific trade. You don't lose *some* value; you can lose *all* of it. This complete, catastrophic outcome is what makes it the most feared risk in the entire process.

The Herstatt Bank Collapse

To understand today's foreign exchange settlement, we must go back to June 26, 1974. This was the day that settlement risk stopped being just a theory and became a scary reality, earning the name “Herstatt Risk.” The main character in this story is Bankhaus Herstatt, a small but very active private bank in Cologne, West Germany.

A Day in 1974

On that terrible day, German financial regulators discovered massive losses in Herstatt's forward foreign exchange trading and made a critical decision. They ordered the bank to be shut down and closed its doors at 4:30 PM local German time.

The timing couldn't have been worse for the global financial system. Throughout that day, Herstatt's trading partners had been making payments to the bank as part of routine foreign exchange transactions. Because of the time zone difference, these partners had paid Deutsche Marks (DEM) to Herstatt during European business hours. They did this expecting to receive their US Dollar (USD) payments later in the day when the US markets opened.

However, when German regulators shut Herstatt down, it was still morning in New York. The bank was now being liquidated. It had received all its DEM payments, but it was now legally unable to make the outbound USD payments to its partners. Those partners, which included major international banks, had paid but would never get paid back. They lost 100% of their money on those trades. The estimated losses at the time were hundreds of millions of US dollars, a huge amount in 1974 that caused a chain reaction.

The Legacy of Herstatt

The Herstatt collapse sent panic through the international banking system. For days, the interbank payment system nearly stopped as banks became terrified to send money to anyone, fearing another Herstatt-style failure. This near-system failure was a serious wake-up call. It showed that the failure of one relatively small bank in one country could threaten the stability of the entire global financial system because of how connected foreign exchange settlement is.

In response, the central bank governors of the G10 countries, working through the Bank for International Settlements (BIS), formed the Committee on Interbank Netting Schemes (which later became the Committee on Payment and Settlement Systems, or CPSS). Its main job was to analyze and find solutions to the problem that Herstatt had so violently exposed. The legacy of that day in 1974 was the beginning of a decades-long, coordinated international effort to control settlement risk, an effort that would ultimately reshape how the global foreign exchange market works.

Comparing Different Risks

To prove that settlement risk is the “greatest,” we need to compare it systematically against other major risks in foreign exchange. While other risks happen more often and are a constant concern, none carry the same potential for catastrophic, system-wide damage as settlement risk. A professional risk manager doesn't only think about how likely an event is but also how bad it could be. In the case of settlement risk, the impact is total.

The Forex Risk Landscape

Before comparing directly, let's briefly define the other key risks in forex:

• Market Risk (or Price Risk): This is the most commonly understood risk. It's the potential for financial loss due to bad movements in exchange rates. If you buy EUR/USD and the Euro weakens against the Dollar, you lose money. This risk is continuous and always present in any open position.
• Credit Risk (or Counterparty Risk): Before settlement, this is the risk that a trading partner defaults on its obligations before the trade settles. For example, you have a profitable forward contract, and the counterparty goes bankrupt. Your loss is the cost of replacing that contract at the new, less favorable market rate.
• Liquidity Risk: This is the risk that you can't execute a trade at or near the quoted price because there aren't enough buyers or sellers in the market. It often shows up as a wide bid-ask spread or significant “slippage,” where the execution price is much worse than expected. It's more a cost of trading than a catastrophic risk.
• Operational Risk: This is the risk of loss from inadequate or failed internal processes, people, and systems, or from external events. This includes everything from a trader entering the wrong trade amount (“fat-finger error”) to a complete failure of a bank's computer systems.

Head-to-Head Risk Comparison

The best way to understand the hierarchy of these risks is to compare them across key measures: how big the potential loss could be, how likely they are to happen, and their potential to spread through the system.

The Verdict on Risk

The analysis from the table is clear. While market risk is constant and highly probable, its losses are typically gradual and can be managed with standard tools like stop-loss orders and hedging strategies. Liquidity risk is a cost of doing business. Operational risk, while potentially severe for a single trade, is usually contained within one institution.

Settlement risk is different. Its probability is low, especially today. Major bank failures don't happen every day. However, the financial industry is built on managing not just likely events, but also unlikely ones with devastating consequences. The size of loss—100% of principal—combined with its demonstrated potential for high system-wide contagion, as seen in the Herstatt case, is what elevates it above all others. A single, large settlement failure could cascade through the system, causing a liquidity crisis and a domino effect of subsequent failures. It is this combination of total loss potential and systemic threat that makes settlement risk, without question, what is considered the greatest risk associated with forex settlement.

Reducing Settlement Risk

The shock of the Herstatt collapse led to a global regulatory and industry-wide effort to engineer a solution. The goal was to eliminate the non-simultaneous nature of settlement that creates principal risk. This led to the development of several key strategies, chief among them a revolutionary market utility that now forms the backbone of global foreign exchange settlement.

The CLS Gold Standard

The primary response to Herstatt risk is CLS, which stands for Continuous Linked Settlement. Launched in 2002, CLS is a specialist financial market infrastructure company, often called CLS Bank. It was created by the world's largest banks specifically to reduce settlement risk in the foreign exchange market. Today, it is the industry gold standard.

According to its own public data, CLS settles an average of $6.5 trillion in payment instructions daily, representing most of global foreign exchange trading volume. It provides its service for 18 of the world's most actively traded currencies, including the USD, EUR, JPY, GBP, and CHF.

The genius of CLS lies in its use of a “Payment-versus-Payment” (PVP) mechanism. In a PVP system, the final transfer of one currency happens if and only if the final transfer of the other currency also happens. It effectively eliminates the time gap. Here is a simplified breakdown of how a trade flows through CLS:

1. Submission: After a trade is agreed upon, both parties submit the matched trade instructions to CLS.

2. Funding: Before the designated settlement window opens, each party must pay the currency it is selling into its dedicated account held at CLS. CLS has accounts with the central bank of each currency it settles.

3. Authentication and Settlement: CLS runs a multilateral netting process on all submitted trades. It then verifies that it has received all necessary funds from all parties.

4. Simultaneous Payout: Only when all funds are verified does CLS simultaneously pay out the netted currency amounts to the respective receiving parties. If one party fails to fund its obligation, the transactions involving that party are removed from the settlement process. The non-defaulting party does not pay out its currency and therefore does not lose its principal. The risk is eliminated.

By acting as a trusted third party that holds both sides of the trade simultaneously, CLS ensures that no party is ever in the position of having paid but not yet been paid.

Beyond CLS Mitigation

While CLS has been incredibly successful, it doesn't cover all currencies. For trades involving emerging market or other non-CLS eligible currencies (often called “exotics”), institutions must rely on other techniques to reduce risk.

The most important of these is bilateral netting. Instead of settling every individual trade separately, two counterparties with multiple trades between them can agree to net their obligations. For example, imagine on a given day, Bank A owes Bank B $50 million and Bank B owes Bank A $48 million from various foreign exchange trades. Instead of two large payments flowing in opposite directions—exposing both to $50M and $48M of settlement risk respectively—they can agree to a single net payment. Bank A simply pays Bank B the net difference of $2 million. This simple act drastically reduces the total value at risk of settlement failure from nearly $100 million to just $2 million. Many institutions have legally binding netting agreements (like an ISDA Master Agreement with a netting addendum) in place with their regular counterparties.

Finally, institutions use strong internal risk management policies. This includes setting strict settlement limits for each counterparty. A treasurer might have a policy that no more than $10 million in non-CLS settlement exposure is permitted with any single counterparty on any given day. This caps the potential loss from a single settlement failure.

A Treasurer's Playbook

Moving from theory to practice, how does a professional in a corporate treasury or at a financial institution actively manage this risk on a daily basis? From our perspective as practitioners, the process is systematic and disciplined. It is not an afterthought; it is a core part of the trading and operations workflow.

Step 1: Measure Exposure

The first principle of risk management is measurement. You cannot manage what you cannot see. On a daily basis, we run reports that add up all unsettled foreign exchange trades. These reports are not just a list of transactions; they are designed to calculate our total settlement exposure. We break this down by counterparty, currency, and settlement date. This gives us a clear figure for our Principal at Risk (PaR)—the total amount that would be lost if a counterparty failed during the settlement window. This daily PaR report is a critical dashboard for senior management.

Step 2: Counterparty Research

We don't trade with just any entity. Before we can execute a single trade, a potential counterparty must go through a rigorous onboarding and research process. Our credit risk team analyzes their financial health, their credit ratings from agencies like Moody's and S&P, and their overall standing in the market. A crucial part of this checklist is specific to settlement risk. We formally ask and verify: “Is the counterparty a direct settlement member of CLS? If not, do they settle via a third-party CLS member? For which currencies do they use CLS?” A counterparty's inability or unwillingness to settle via CLS for eligible currencies is a major red flag and could be grounds for prohibiting a trading relationship.

Step 3: Enforce Procedures

Clear and non-negotiable internal policies are the foundation of our defense. Our treasury policy manual explicitly requires that all foreign exchange trades in the 18 CLS-eligible currencies must be settled via CLS. There are no exceptions. This is an automated and audited part of our trade processing workflow. For trades in non-CLS currencies, a different set of strict procedures applies. We rely on legally enforceable bilateral netting agreements. Furthermore, we apply strict settlement limits to each counterparty for these trades. If a proposed trade would cause us to exceed our pre-agreed exposure limit with a counterparty, the trade is automatically flagged and requires explicit approval from the Head of Treasury or the Chief Risk Officer.

Step 4: Emergency Planning

We operate on a “trust but verify” model. While we trust our systems and our major counterparties, we plan for failure. We have a detailed emergency plan that outlines the exact steps to be taken in the event of a counterparty default during the settlement window. This plan includes immediate internal and external communication protocols, a checklist for gathering all relevant trade and payment documentation, and the immediate engagement of our legal department to begin any necessary proceedings. The goal is to react swiftly and systematically to contain the damage and begin the recovery process without delay.

Conclusion: Ongoing Challenge

The journey through the landscape of forex risk leads to an unavoidable conclusion. Settlement risk, made real by the historic collapse of Bankhaus Herstatt, remains the top threat due to its unique potential for 100% principal loss and its capacity to trigger system-wide financial contagion. It is the definitive answer to the question of what is considered the greatest risk associated with forex settlement.

A Risk Under Control

Fortunately, this is not a story without a solution. The financial industry's response, led by the creation of CLS Bank and its Payment-versus-Payment mechanism, represents one of the most successful risk reduction triumphs in modern finance. The vast majority of the world's foreign exchange trades are now protected from this once-widespread threat. Complemented by disciplined bilateral netting and rigorous internal controls, the risk has been effectively controlled for a large portion of the market.

However, it has not been completely eliminated. The risk remains very real for transactions in currencies outside the CLS umbrella and serves as a constant reminder of the importance of robust counterparty research. For every corporate treasurer, risk manager, and institutional trader, understanding, measuring, and actively managing settlement risk is not merely a best practice—it is a fundamental pillar of survival and stability in the interconnected global financial marketplace. Vigilance remains the ultimate currency.