What it means
The problem comes from time zones. Currency trades settle in two different national payment systems that are open at different hours, so one leg of a trade is often paid hours before the other, and during that gap you are simply an unsecured creditor of your counterparty.
If they collapse inside that window, you have handed over real money and received nothing. What makes this risk distinctive is its size relative to the trade.
Ordinary market risk on a currency deal is a small percentage of the notional amount, but Herstatt risk is the entire principal you paid away. A trade that would have made a modest margin can, in the worst case, cost you the full value of the currency you delivered.
The industry response was payment-versus-payment settlement, where both legs are released only if both are funded, so neither side can be stranded. A shared settlement utility used by the major currency dealers now handles the large majority of interbank foreign exchange this way.
Where it is not available, banks fall back on bilateral netting, tighter counterparty limits and shorter settlement windows. Treasury teams outside banking still meet this risk when they settle large currency conversions directly with a counterparty rather than through a settlement service.
The practical questions to ask a bank or broker are whether the trade settles payment-versus-payment, and if not, how long the gap between the two legs will be. A gap of several hours with an unrated counterparty is a genuine exposure, not a technicality.
In practice
Real-world examples
Example 1
A manufacturer converts $30,000,000 into yen to prepay a component supplier and settles bilaterally with a small regional bank. Its treasurer only realises afterwards that the dollar leg left six hours before the yen leg was due, meaning the firm carried full principal exposure to that bank for most of a business day.
Example 2
An asset manager rebalances a global fund and asks its custodian to confirm that all currency legs settle payment-versus-payment. Two of the smaller emerging market currencies do not qualify, so the manager splits those trades into smaller amounts across several days to cap exposure to any single settlement window.
Example 3
A corporate treasury team sets a rule that no single unsettled currency leg may exceed $10,000,000 with any counterparty rated below a defined threshold. A $28,000,000 conversion is therefore executed as three separate trades with three different banks rather than one large ticket.
Think of it
Herstatt risk is FX danger from time zones-paying in one currency before receiving the other.
Formula
Calculation
Herstatt exposure = full value of the currency already paid away, held from the moment your payment becomes irrevocable until the counterparty's payment is confirmed received.
Suppose a company sells 45,000,000 euros and buys US dollars at a rate of $1.10 per euro. It instructs its euro payment in the morning European settlement window and expects dollars later the same day: 45,000,000 x 1.10 = $49,500,000 due in.
Once the euro payment is irrevocable and before the dollars arrive, the exposure is the whole $49,500,000 equivalent, not the trading margin on the deal. If the counterparty fails during that window, the company joins the queue of unsecured creditors for the full amount, even though the exchange rate itself never moved against it.Case study
Seen in the real world
The following is an illustrative and entirely fictional scenario. Calder Marine Supplies, an invented shipping outfitter, settled most of its currency needs through its main clearing bank but used a smaller specialist broker for a large one-off euro payment because the quoted rate was 0.3% better.
The broker took Calder's dollars at nine in the morning and was due to deliver euros that afternoon. Nothing went wrong, but during an internal review Calder's auditor pointed out that the firm had been exposed to the full $22,000,000 for roughly seven hours in exchange for a rate saving of about $66,000.
In this fictional case, Calder kept the broker relationship but capped any single unsettled leg at $5,000,000 and required same-window settlement for anything larger. The saving on rates fell, but the treasurer could explain the trade-off to the audit committee in one sentence.
Watch out
Common mistakes
- Thinking Herstatt risk is a type of exchange rate risk. The exchange rate is irrelevant here; the loss comes from paying one currency and never receiving the other, which would hurt just as much if rates never moved.
- Assuming the exposure equals the profit on the trade. The exposure is the entire principal you have already delivered, which is typically many times the margin you expected to earn.
- Believing modern payment systems have eliminated it entirely. Payment-versus-payment settlement covers most major currency pairs between large dealers, but plenty of emerging market currencies and smaller counterparties still settle with a real gap.
Questions
People also ask
Why is it named after Herstatt?
A German bank of that name was closed by regulators mid-day in 1974, after counterparties had paid it deutschmarks but before it had paid the corresponding dollars, and the episode gave the risk its lasting name.
How long does the exposure typically last?
Anywhere from a couple of hours to more than a day, depending on the time zones and cut-off times of the two payment systems involved.
Can a smaller company do anything about it?
Yes, by asking whether trades settle payment-versus-payment, splitting very large conversions into smaller tickets, and setting a cap on unsettled amounts per counterparty.