Settlement Risk vs. Credit Risk

What is the difference between the two? In the risk management section it says settlement risk is a non-financial risk whereas credit risk is a financial risk. The descriptions of the two sound the same to me. What’s the difference?

Settlement Risk --> Risk that counterparty will fail to deliver the terms of a contract. Credit risk --> default risk, downgrade risk, credit spread risk

Settlement Risk = Herstatt Risk

not trying to be too picky but surely failure to delivery is the same as default risk?

a firm can fail to deliver on a contract standalone but need not go bankrupt. so failure to settle a contract is not the same as default.

Also the counterparty may not be the same as the instument. For instance, Lehman Brothers sells you a Goldman Sachs bond. Your credit risk is GS. Your settlement risk is LEH.

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Still why would Settlement risk be non-financial risk while credit risk be financial risk? How to really distinguish whether it is financial or non-financial risk?

You cannot model Settlement risk , no one will sell you an instrument to cover this risk. For credit risk there are all kinds of vehicles from derivatives to collateral postings which are all forms of financial instruments

Thanks janakisri!

Just need clarification, because to me settlement risk has an element of credit risk. Example, I terminate a derivative contract with a derivative counterparty. Assume that I am owed money and it takes two days for the contract to be settled. Wouldn’t I still have to account for risk of the counterparty failing/not being able to deliver in the next two days?

I think you’re describing the credit risk part of the contract. but I am not sure who settles such a contract. If it is exchange traded thyere is little to zero credit risk, if it is with a AAA bank you probably have recourse of some kind ( maybe a bailout? )

This happens all the time in derivative contracts not traded on the exchange.

BTON04 Wrote: ------------------------------------------------------- > This happens all the time in derivative contracts > not traded on the exchange. - to restate this correctly, the settlement risk exists i derivative contracts that are traded between two counterparties (eg GS and Morgan Stanley). And yes my point was that settlement does involve an element of “credit risk”, therefore was seeking clarification.

I think settlement risk comprises both credit risk and liquidity risk ( but with a focus on liquidity ) . Credit risk ALONE by itself denotes that one party is insolvent and is not likely to ever be able to settle. In settlement risk , they may miss a payment or two but are otherwise solvent.

I think settlement risk comprises both credit risk and liquidity risk ( but with a focus on liquidity ) . Credit event ALONE by itself denotes that one party is insolvent and is not likely to ever be able to settle. In settlement risk event , they may miss a payment or two but are otherwise solvent. settlement risk event can happen due to liquidity without credit event happening , due to temporary liquidity crisis . But can happen due to other horrible or shady circumstances as well: Schweser points to Hertstatt when a German bank was told to stop business at the end of the current day , but had already taken in payments from various counterparties. At the end of the day , these counterparties did not get their dues in foreign currencies or whatever instrument they had paid for ( cash flows ) .They became fully exposed even when they were almost fully hedged against this bank on their books. This kind of problem is impossible for a default model to capture Morning : full faith , Evening : Fully busted. i.e. settlement risk event occurred.

total credit risk encompasses counterparty risk, transfer risk, and settlement risk

Credit Risk is Risk of default due to counter party failure to honour its commitment on due date. Now the failure could be on account of factors like credit worthiness related or wilful default. To the core, settlement risk is a risk that could be either due to credit factors or others like Cross Border Risk which include Country or Sovereign risk including conversion or transfer risk, regulatory risk, legal risk Liquidity risk is a part of the broader Credit Risk like Solvency Risk. Practically speaking, some examples of Settlement Risks could be Agent Bank risk in a Syndication, Corresponding Bank risk in a forex transaction, Clearing House risk in a trade settlement, Seller risk in a risk participation on undisclosed basis or even disclosed basis.

Replying nine years later probably doesn’t have much practical value, especially as settlement risk is no longer in the Level III curriculum.

Oh, thats really funny. I came across this forum thru google today and wanted to clarify on both the risks. Unfortunately, i could not see the years in dates of comments.

Okay, it is month and year. I i initially got it month and date.