Settlement Risk and Currency Markets

Settlement risk is a central friction in currency markets. We provide causal evidence on its pricing by exploiting Hungary's 2015 adoption of CLS, which introduced payment-versus-payment settlement, sharply reducing settlement risk. Using a difference-in-differences design, we find that currency excess returns decline by about ten basis points after CLS adoption, consistent with lower compensation for bearing settlement risk, while exchange rate volatility also falls. Deviations from triangular arbitrage conditions narrow, indicating a reduction in the effective cost of arbitrage and improved market efficiency. Additional evidence based on U.S.-specific holidays supports a mechanism operating through time-zone exposure. Our findings show that settlement risk is a priced friction and a source of limits to arbitrage in currency markets.