FRM Exam Part II · Margin (Collateral) and Settlement

Settlement Risk and Payment Systems: Herstatt, DvP, PvP and CLS

Updated 11 October 2026 · Fact-checked

Settlement risk is the risk that you deliver your side of a trade but the counterparty fails to deliver theirs. In FX it is called Herstatt risk. You remove it by making the two legs settle together: delivery-versus-payment for securities, payment-versus-payment for currencies, as CLS does.

Understand Settlement Risk and Payment Systems

Settlement risk arises because the two sides of a trade settle at different times. You pay first, the other side fails, and you lose the full amount you paid. This is different from normal credit risk on a derivative, where the loss is only the replacement cost.

Herstatt risk is the name for this in foreign exchange. In 1974 Bankhaus Herstatt in Germany was closed by regulators during the business day. It had already received Deutsche marks from counterparties, but the US dollars it owed in return were never paid in New York. The time zone gap between the two currency payments created the loss. Today the same gap exists between, for example, INR, JPY, EUR and USD payment systems.

Settlement risk is not the same as pre-settlement risk. Pre-settlement risk runs from trade date until settlement date. If the counterparty defaults then, you lose only the cost of replacing the trade at current market prices, which can be zero or a gain. Settlement risk exists only on the settlement date, during the window when you have paid and not yet received. Your exposure is the full principal of the leg you paid.

The fix is to link the two legs so that one happens only if the other does. Delivery-versus-payment (DvP) links the transfer of a security to the transfer of cash. Payment-versus-payment (PvP) links the transfer of one currency to the transfer of another. CLS Bank is the main PvP system in FX. It settles both currency legs at the same time in central bank money, so the principal risk largely disappears.

CLS does not remove everything. Only trades in CLS-eligible currencies and submitted by members are covered. Members still fund through pay-in and pay-out schedules, which creates liquidity demands. Trades outside CLS, such as those in non-eligible currencies, still carry Herstatt risk. Netting of payins through CLS also cuts the funding needed, since only net positions per currency are paid in.

Key formulas to remember

Settlement risk exposure: Exposure = full principal of the leg you have paid and not yet received; The loss can be the whole amount, not just replacement cost.
Pre-settlement risk exposure: Exposure = max(MTM replacement cost, 0); Applies from trade date to settlement date. Much smaller than principal.
Settlement risk window: Window = time between irrevocable payment of your leg and confirmed receipt of the other leg; Time zone differences in FX widen this window.
DvP and PvP rule: DvP: security ↔ cash. PvP: currency A ↔ currency B. Each leg final only if the other is final; Both remove principal risk; neither removes market risk before settlement.
Multilateral netting of pay-ins: Net pay-in per currency = Σ amounts to pay − Σ amounts to receive; Used by CLS to lower funding needs. Gross trade value is much larger than net pay-in.

How to solve Settlement Risk and Payment Systems questions

Use this method for any question on settlement risk, Herstatt risk, DvP, PvP or CLS.

1Identify the trade type: FX spot or forward, or a securities trade against cash.
2Separate the two phases: pre-settlement (trade date to settlement date) and settlement (the day legs move).
3Find the exposure. Pre-settlement: replacement cost only. Settlement: full principal of the leg paid.
4Check whether the legs are linked. If one can be paid without the other being final, principal risk exists.
5Match the mitigant: DvP for securities against cash, PvP or CLS for currency against currency.
6Check the limits: eligible currencies, CLS membership, trades settled outside CLS, and liquidity or funding needs.
7Read the answer options for traps such as calling settlement risk market risk or saying CLS removes all counterparty risk.

Quickest way: Two-question shortcut

When to use it: When you have under a minute per question and the stem is short.

Ask: is the loss the full principal or only replacement cost? Full principal means settlement risk. Replacement cost means pre-settlement risk.
Ask: are both legs settled together? If yes, it is DvP or PvP. If no, Herstatt risk remains.
If the trade is in a CLS-eligible currency pair through a member, expect the answer to say principal risk is largely removed.
Eliminate options that say CLS removes replacement cost risk before settlement date.

Common mistakes in Settlement Risk and Payment Systems

Treating settlement risk as the same as pre-settlement risk.
Both are counterparty credit risk, so they look alike.
Fix: Tie settlement risk to the settlement date and full principal. Tie pre-settlement risk to the period before it and replacement cost.
Saying CLS eliminates all FX counterparty risk.
CLS is often described as removing Herstatt risk.
Fix: CLS removes principal settlement risk for eligible trades. Replacement cost risk before settlement and risk on non-CLS trades remain.
Mixing up DvP and PvP.
The names are similar.
Fix: DvP pairs a security with cash. PvP pairs two currencies. FX is PvP.
Assuming the loss in Herstatt risk is the market value change.
Students default to the derivative exposure idea.
Fix: The loss is the principal paid and not received, which can be the full notional of that leg.
Ignoring liquidity effects of CLS.
Focus is only on credit risk reduction.
Fix: Remember that members must meet pay-in schedules on time. Netting lowers the amounts, but a member short of funds can cause stress.

Worked examples

Example 1

A bank agrees to sell USD 10 million and buy EUR 9.2 million. It pays the USD leg in New York in the morning but the EUR leg arrives in Frankfurt later. The counterparty fails after the USD payment. Replacement of the trade would cost the bank USD 50,000 at current prices. What is the settlement risk exposure and what limits the loss if the trade had been settled through CLS?

Show the solution

The bank has paid USD 10 million and not received the EUR leg.
Settlement risk exposure is the full principal paid: USD 10 million.
The USD 50,000 is replacement cost, which is pre-settlement style exposure and is much smaller.
Through CLS, both legs settle at the same time (PvP). The USD payment would be final only if the EUR payment is final.
So the principal loss is avoided and the bank faces at most the replacement cost issue on the unsettled trade.

Answer: Settlement risk exposure is USD 10 million, not USD 50,000. With CLS PvP settlement, the principal risk is largely removed.

Example 2

Which statement about settlement risk in FX is correct? A) It equals the positive mark-to-market value of the trade. B) It arises because the two currency payments may not occur at the same time. C) It is removed for all FX trades by DvP. D) It begins on the trade date and ends at maturity of the contract.

Show the solution

A describes replacement cost, which is pre-settlement risk. Incorrect.
C is wrong: DvP applies to securities against cash, and not all FX trades are covered by any single mitigant.
D describes the period of pre-settlement risk. Settlement risk is concentrated on the settlement date.
B matches Herstatt risk: the legs settle at different times, often due to time zones.

Answer: B

Exam tips

Look for the words full principal or entire amount. They signal settlement risk, not replacement cost.
Expect questions that ask which mitigant fits which trade: DvP for securities, PvP for currencies.
If an option says CLS removes all counterparty risk, it is almost certainly wrong.
Read for trades in currencies not eligible for CLS. Herstatt risk remains for them.
Link this topic to intraday liquidity, since CLS pay-in schedules and RTGS systems create intraday funding needs.

Practice questions from Margin (Collateral) and Settlement

Settlement Risk and Payment Systems: frequently asked questions

What is Herstatt risk in simple terms?

It is the risk that you pay one currency and the counterparty fails before paying the other. It is named after Bankhaus Herstatt, closed in 1974 after receiving Deutsche marks but before paying US dollars. The loss can be the full principal.

What is the difference between settlement risk and pre-settlement risk?

Pre-settlement risk runs from trade date to settlement date and the loss is replacement cost. Settlement risk occurs on the settlement date when you have paid but not received, and the loss can be the full principal.

How does CLS Bank reduce settlement risk?

CLS uses payment-versus-payment. Both currency legs of an eligible trade settle together in central bank money, so one is final only if the other is. It also nets pay-ins to reduce funding needs.

What is the difference between DvP and PvP?

DvP links the transfer of a security to the payment of cash. PvP links the payment of one currency to the payment of another. Both remove principal risk by making the legs conditional on each other.