What does Herstatt risk refer to?

Herstatt risk specifically refers to the risk of loss that arises when one party in a foreign exchange transaction fails to complete its side of the deal after the counterparty has already completed its part. This situation often occurs due to timing differences in the settlement of transactions across different time zones. In the Herstatt Bank case, which was highlighted for its significant operational issues, the bank failed to deliver the currencies it was supposed to provide after a counterparty had already paid, leading to substantial financial losses.

This risk is particularly pertinent in foreign exchange markets, where the settlement of transactions can be impacted by the presence of differing banking hours and operational capabilities across international borders. Understanding Herstatt risk is crucial for financial institutions and participants in foreign exchange markets to mitigate potential losses and ensure robust settlement processes.