3.1 Participants in both clearing systems and typical financial markets are exposed to several types of financial risk. First, they bear credit risk. This is the risk that a counterparty will not meet an obligation when due, and will never be able to meet that obligation for full value. The bankruptcy of a counterparty is often associated with such difficulties, but there may be other causes as well. In a payment netting system, losses from defaults due to the bankruptcy of counterparties can be measured as the principal amount due less recoveries from defaulting parties. Forgone interest can also be an important loss. In an obligations netting system, losses from the default of a counterparty would typically be calculated from the replacement costs of one or more contracts that are not settled. If, however, one party to a contract defaults after having received settlement payments from another party, but before making required counter-payments (in the same or another currency), the loss would again be for a principal amount (less recoveries). 3
3.2 Second, participants bear liquidity risk. Narrowly defined, this is the risk that clearing, or settlement, payments will not be made when due, even though one or more counterparties do have sufficient assets and net worth ultimately to make them. For example, a temporary inability to convert assets to cash, operational difficulties of various kinds, or the inability of correspondents to perform settlement functions will all create liquidity problems.
3.3 The risk that a party will default on clearing obligations to one or more counterparties is sometimes referred to as settlement risk. This risk may contain elements of either credit risk or liquidity risk, or both. The usage of the term "settlement risk" varies considerably, and may also depend on the situation being analysed. For purposes of clarity in this report, the term is not used or discussed further. Instead, the concepts of credit or liquidity risk are employed when one of these is the ultimate financial risk being addressed.
3.4 The concept of liquidity risk is usually defined more broadly, with reference to a whole range of obligations that participants in financial markets incur, including payments due within specific clearing systems. The risk is that a financial market participant will have insufficient liquid resources to make all its payments on the due date, including its liabilities in a payment system. This notion is useful because it implicitly recognises that liquidity problems in a payment system can add to, or be part of, much larger liquidity difficulties in an economy.
3.5 Third, payment systems and financial markets generally can be subject to system, or systemic, risk. This is the risk that the inability of one participant in a payment system, or in the financial markets, to meet obligations when due will cause other participants to fail to meet their obligations when due. For some analytical purposes it is possible to distinguish "systemic liquidity risk" from "systemic credit risk". Of the various kinds of risk, it is usually systemic risk in some form that is of most concern in assessing the risks associated with payment systems.
Footnotes:
3. Administrative and similar expenses are usually associated with any defaults.
