Settlement Risk Limits

Settlement risk limits are ideal for trading and investment.

Settlement risk is the risk of loss. It is an investment term industry professionals use to refer to one party's failure to meet a clearing obligation to one or more parties. Settlement risk limits are policies in which companies and government design objectives to mitigate loss.

Market Risk

The two types of market risk limits, capital-based and earnings-based, establish limits to prevent potential threat to the viability of a bank. A company's or government's board of directors establishes settlement risk limits on assets, securities and earnings.

Maturity Limits

Companies and governments may prevent management from purchasing investment instruments with longer term maturities. Within some investment companies, management may only place settlement risk limits on securities with a higher price risk and interest rate.

Liquidity Risk

Companies may establish settlement risk limits related to liquidity risk. Management places liquidity risk limits on those securities that are difficult to sell at fair value.

Clearing Agent

Investment trading companies close transactions through a clearing agent to prevent settlement risk. The clearing agent functions as a stakeholder, settling transactions between both parties. Companies also develop netting agreements, or bilateral payment contracts, for overseas transactions. This allows companies to settle trades simultaneously.

References

• Risk Institute: Definition of Settlement Risk
• FDIC: Risk Management Manual of Examination Policies
• Deutsche Bank: Settlement Risk Policy

Resources

• Federal Reserve Bank of New York: Report on Settlement Risk