Counterparty risk

Counterparty risk exists whenever there is a gap between agreement and final settlement: the longer the cycle, the greater the exposure. In securities settlement it shows up during the settlement window; in FX it is known as Herstatt risk, after the German bank that in 1974 received payments but closed before delivering the opposite leg. Traditional finance mitigates it with central counterparties (CCPs) that interpose themselves between buyer and seller, backed by margin and guarantee funds, and with delivery versus payment (DvP), where delivery and payment are mutually conditioned.

It is the risk that justifies much of the market's infrastructure and cost. Tokenization's central thesis is that representing asset and money on a single ledger enables atomic settlement: the simultaneous, irreversible exchange of both legs in one all-or-nothing transaction that, by removing the time gap, neutralizes settlement risk. It is implemented with techniques such as HTLCs (hashed timelock contracts) or smart contracts that condition both legs. It is also the risk side of undercollateralized lending, where without automatic liquidation the credit is essentially counterparty exposure.

Settlement cycles are being shortened to narrow this window: the United States moved to T+1 in May 2024, and ESMA has proposed the shift from T+2 to T+1 in the European Union, with implementation slated for 11 October 2027. In parallel, institutional atomic-settlement pilots on tokenized assets are advancing, such as DTCC's work with US Treasuries on Canton Network, which show how on-chain atomic DvP aims to neutralize this risk.