A beginner's guide to settlement risk

When you buy shares, the money and the shares do not change hands at the exact moment of the trade. In that gap, something can go wrong. This is settlement risk. This page explains what it means, a famous case and how India has reduced it.

Quick answer

Settlement risk is the risk that one party in a trade delivers its side, such as money or securities, but does not receive what it is owed from the other party. It arises because there is a time gap between a trade and its final settlement. Shorter settlement cycles and delivery-versus-payment systems reduce this risk. India moved fully to T+1 settlement for shares in January 2023.

Key takeaways

• Settlement risk comes from the gap between trade and settlement.
• It is the risk of paying or delivering without receiving.
• The 1974 Herstatt Bank failure is a classic example.
• India completed the move to T+1 settlement in January 2023.
• Delivery versus payment systems reduce this risk.

What is settlement risk?

A trade is agreed in seconds, but final settlement, when money and securities actually move, takes longer. During that time, one party might fail, or a payment might go through on one side and not the other.

This risk is closely related to counterparty risk. The difference is timing. It is specifically about the moment of exchange, when one side may have delivered and is waiting to receive.

A famous example: Herstatt

In June 1974, German regulators closed Bankhaus Herstatt during the business day. Some banks had already paid German marks to Herstatt in Europe, expecting US dollars in New York later that day because of the time difference. The dollars never arrived.

Because of this case, settlement risk in foreign exchange is often called 'Herstatt risk'. It led to global efforts to improve payment systems, including the creation of CLS, a system that settles both sides of currency trades at the same time.

How India reduced settlement risk in shares

India shifted to T+1 settlement in phases, and the move was completed for all listed shares on 27 January 2023. India was among the first major markets to do this. An optional T+0 cycle was later introduced for a limited set of shares.

A shorter cycle means fewer open trades at any time, so less can go wrong between trade and settlement. Clearing corporations also guarantee settlement, protecting investors if a member defaults.

Delivery versus payment

Delivery versus payment (DvP) means securities move only if payment moves at the same time. If one side fails, neither side transfers. The RBI and CCIL use DvP for government securities in India, which removes the risk of delivering without being paid.

Why it matters for investors

For ordinary share investors in India, the clearing system handles most of this risk. Knowing how settlement works helps you understand why shares and funds reach your account on a set schedule and why shorter cycles are safer for the market.

Frequently Asked Questions