The concepts and consequences of pre-settlement and settlement risks are well understood in the growing foreign exchange market. Globally steps have been taken to mitigate these risks. Settlements systems, which remained almost the same for the last 300 years have seen changes in the last decades with CCIL taking the lead role in India and Continuous Linked Settlement (CLS) for major world currencies. CLS aims at eliminating settlement risks in CLS currencies covering more than half of world forex trade. As per an independent survey, CLS is likely to have a market share of over 80% in the next few years. In India, six banks have already become fourth party members and a large number of others are in the process of finalizing steps for availing CLS service.

In any trade transaction where two commodities or two monetary units or one commodity and one monetary unit are exchanged, if the two `legs' of the transaction i.e., payment or delivery by each party takes place simultaneously, then obviously there is no risk if one `leg' of the transaction is not taking place. When payments are not exchanged simultaneously, generally arising due to time differences, one party is likely to suffer. This risk of possible loss can be either prior to the date and time of delivery or at the time of settlement. Fortunately, we do not have a post settlement risk to add to these!

The two risks are respectively called pre-settlement and settlement risks. The two have different significances in quality and quantity of underlying risk. Settlement risk is the risk that one party does not deliver the security or its value in cash as per the agreement after the other counterparty has delivered security or cash value as per the agreement. One party to a transaction may have affected payment or delivery in an earlier time zone without having confirmation of the receipt of a reciprocal asset in a later time zone. This is also known as the Herstatt Risk.

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