Herstatt Risk

inSight

11 Nov 1999

Herstatt Risk

Joseph Yam writes: When I launched this column in early September I said that I would from time to time be inviting contributions from colleagues in the HKMA. Having produced all ten of the Viewpoint columns so far myself, I thought it was time to deliver on that promise before someone accused me of monopolistic practices. It is therefore with great pleasure that I introduce Tony Latter, Deputy Chief Executive, as our columnist for this week. Tony featured prominently in my account of the creation of the Linked Exchange Rate system in last week's column. This week he delves further into history with a reflection on an event twenty-five years ago that still preoccupies central banks.

 

SILVER ANNIVERSARY

Twenty-five years on, Herstatt risk is still with us. But progress in real time settlement systems may one day make it a thing of the past.

Nineteen-ninety-nine marks the 25th anniversary of the Herstatt crisis. Bank Herstatt was closed down by the West German authorities when they realised that, largely as a result of excessive gambling in the foreign exchange market, the bank would be unable to meet its commitments. The authorities took this action after the European markets had closed for the day, but while New York was still open. The European leg of foreign exchange deals had been settled but, once news of the closure hit New York, all trades involving Herstatt were suspended, so that counterparties who had already been debited in Europe did not receive the corresponding dollar amounts due to them in New York.

This episode marked the starting point for a massive escalation in the attention which central banks gave to assessing and guarding against settlement risk in payments procedures, particularly in respect of foreign exchange transactions, where the two legs may be settled in different jurisdictions and in different time zones. The term "Herstatt risk" has become entrenched in the vocabulary of banks and regulators alike. The founding fathers of that now long extinct bank might have wished for a somewhat different memorial.

Despite the passage of a quarter of a century, and the huge efforts at risk reduction by the world's financial regulators, Herstatt risk is still with us. Fortunately, however, awareness that the risk exists has mostly been enough to prevent it manifesting itself. Failure to have nevertheless resolved the problem, even after so long, can, I suppose, be explained by the technical complexities of payment systems as well as by the obstinate truth that ultimate finality of settlement in a particular currency involves the home central bank and has traditionally been effected only at the end of day in that place. However, the development in recent years of real-time settlement in national payment systems has altered the scenery and opened the way to eventual elimination of Herstatt risk - if real-time settlement for the two currencies of a deal can be linked appropriately. Progress is being made in this direction by the establishment of CLS Bank (the initials stand for Continuous Linked Settlement), which should commence business in about a year's time, from an operational base in Europe, providing real-time payment-versus-payment settlement between participating currencies. Mainly for technical reasons, initial participation will be confined to only five or six major currencies, but we are examining the possibility of the Hong Kong dollar joining as one of the second wave. Meanwhile in Hong Kong we are exploring arrangements for a US dollar clearing process, which would help towards reducing Herstatt risk for part of the foreign exchange market here.

Perhaps one day, therefore, we shall finally bid farewell to Herstatt. But, for the moment, to the ghost of Herstatt, Happy Anniversary!

 

Tony Latter
11 November 1999

 

More information on the Settlement and Payment Systems can be found here.

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Last revision date : 11 November 1999