A German Bank Closed at Lunchtime and Created a Global Rule
Herstatt Bank was shut by regulators in 1974 partway through the settlement day. Counterparties had already paid and never received the other side, and foreign exchange settlement was rebuilt because of it.
The Failure
Bankhaus Herstatt was a mid sized German bank that had accumulated large losses in foreign exchange trading. German regulators withdrew its licence and ordered it into liquidation during the business day in June 1974.
The timing was the problem. By the time the bank was closed in Germany, counterparties in that day's currency trades had already paid Deutsche Marks to Herstatt. Those trades required Herstatt to pay dollars in New York later the same day, and because the American business day had not yet begun, those dollar payments were never made.
Counterparties had delivered one currency and received nothing in return.
Why the Structure Creates This
A foreign exchange trade involves two payments in two currencies, and each currency settles through its own national payment system operating in its own time zone.
There is no mechanism inherent to the trade ensuring both legs occur or neither. The party paying the currency whose market closes earlier delivers first and then waits, exposed for the intervening hours to the possibility that the counterparty fails before reciprocating.
For the hours between the two payments, a currency trade is an unsecured loan of the full principal amount rather than an exchange.
Why Principal Risk Is Different
The exposure is not the change in the exchange rate, which would be a manageable market risk. It is the entire principal.
If a counterparty fails after you have paid, you have lost the full amount delivered, not the small difference between the agreed rate and the current one. Given daily foreign exchange turnover in the trillions, aggregate exposure of this kind across the system is enormous.
What It Produced
The failure was a direct cause of the formation of the Basel Committee on Banking Supervision later in 1974, as central banks recognised that bank failures had cross border consequences requiring coordinated oversight.
The operational solution took considerably longer. A settlement institution was eventually established to provide payment versus payment settlement, in which both legs of a currency trade settle simultaneously or neither settles. That structure eliminates the timing gap by making the two payments conditional on each other.
A large share of global foreign exchange turnover now settles through such arrangements, though a meaningful portion still settles bilaterally and retains the original exposure.
The General Principle
The underlying concept is delivery versus payment, and it appears throughout finance. Securities settlement systems are designed so that securities and cash change hands simultaneously. Escrow arrangements in property transactions serve the same purpose.
Whenever an exchange is not simultaneous, whoever performs first is extending credit for the interval, whether or not anyone describes it that way. Identifying who performs first, and for how long, is a habit worth applying to any transaction structure.
The Bottom Line
Herstatt showed that a currency trade contains hours during which one side has paid and the other has not, and the exposure is the whole principal. Wherever performance is not simultaneous, someone is lending.