Settlement (finance)
Encyclopedia
Settlement of securities is a business process
whereby securities
or interests in securities are delivered, usually against (in simultaneous exchange for) payment
of money, to fulfill contract
ual obligations, such as those arising under securities trades.
In the U.S., the settlement date
for marketable stocks is usually 3 business days after the trade is executed, and for listed options and government securities it is usually 1 day after the execution.
As part of performance on the delivery obligations entailed by the trade, settlement involves the delivery of securities and the corresponding payment.
A number of risks arise for the parties during the settlement interval, which are managed by the process of clearing
, which follows trading and precedes settlement. Clearing involves modifying those contractual obligations so as to facilitate settlement, often by netting
and novation
.
and securities held in electronic form, securities settlement had involved the physical movement of paper instruments, or certificates and transfer forms. Payment was usually made by paper check
upon receipt by the registrar
or transfer agent
of properly negotiated certificates and other requisite documents. Physical settlement securities still exist in modern markets today mostly for private (restricted or unregistered) securities as opposed to those of publicly (exchange) traded securities, however payment of money today is typically made via electronic funds transfer
(in the U.S., a bank wire transfer
made through the Federal Reserve's Fedwire
system). Physical/paper settlement involves higher risks, inasmuch as paper instruments, certificates, and transfer forms are subject to risks electronic media are not more or less such as loss, theft, counterfeit, and forgery (see indirect holding system
).
The U.S. securities markets experienced what became known as "the paper crunch," as settlement delays threatened to disrupt the operations of the securities markets which led to the formation of electronic settlement via a Central Securities Depository
, specifically the Depository Trust Company (DTC
), and ultimately its parent, the Depository Trust & Clearing Corporation. In the United Kingdom
, the weakness of paper-based settlement was exposed by a programme of privatisation of nationalised industries in the 1980s, and the Big Bang of 1986
led to an explosion in the volume of trades, and settlement delays became significant. In the market crash of 1987, many investors sought to limit their losses by selling their securities, but found that the failure of timely settlement left them exposed.
. This report made nine recommendations with a view to achieving more efficient settlement. This was followed up in 2003 with a report, Clearing and Settlement: A Plan of Action, with 20 recommendations.
In an electronic settlement system, electronic settlement takes place between participants. If a non-participant wishes to settle its interests, it must do so through a participant acting as a custodian. The interests of participants are recorded by credit entries in securities accounts maintained in their names by the operator of the system. It permits both quick and efficient settlement by removing the need for paperwork, and the simultaneous delivery of securities with the payment of a corresponding cash sum (called delivery versus payment
, or DVP) in the agreed upon currency.
ual and therefore personal
. Because they are merely personal, their rights are at risk in the event of the insolvency of the vendor. After settlement, the purchaser owns securities and their rights are proprietary. Settlement is the delivery of securities to complete trades. It involves upgrading personal rights into property rights and thus protects market participants from the risk of the default of their counterparties.
or more than one, which is/are electronically linked to a settlement system. Securities (either constituted by paper instruments or represented by paper certificates) are immobilised in the sense that they are held by the depository at all times. In the historic transition from paper-based to electronic practice, immoblisation often serves as a transitional phase prior to dematerialisation.
The Depository Trust Company in New York is the largest immobilizer of securities in the world. Euroclear
and Clearstream Banking
, Luxembourg
are two important examples of international immobilisation systems. Both originally settled eurobond
s, but now a wide range of international securities are settled through them including many types of sovereign debt and equity
securities.
, participants hold the underlying securities directly. The settlement system does not stand in the chain of ownership, but merely serves as a conduit for communications of participants to issuers.
It is important to note that, in the U.S., the settlement date/terms for a securities trade is also associated with the character or basis on which the securities trade and settle:
Business process
A business process or business method is a collection of related, structured activities or tasks that produce a specific service or product for a particular customer or customers...
whereby securities
Security (finance)
A security is generally a fungible, negotiable financial instrument representing financial value. Securities are broadly categorized into:* debt securities ,* equity securities, e.g., common stocks; and,...
or interests in securities are delivered, usually against (in simultaneous exchange for) payment
Payment
A payment is the transfer of wealth from one party to another. A payment is usually made in exchange for the provision of goods, services or both, or to fulfill a legal obligation....
of money, to fulfill contract
Contract
A contract is an agreement entered into by two parties or more with the intention of creating a legal obligation, which may have elements in writing. Contracts can be made orally. The remedy for breach of contract can be "damages" or compensation of money. In equity, the remedy can be specific...
ual obligations, such as those arising under securities trades.
In the U.S., the settlement date
Settlement date
Settlement Date is a securities industry term describing the date on which a trade settles. That is, the actual day on which transfer of cash or assets is completed....
for marketable stocks is usually 3 business days after the trade is executed, and for listed options and government securities it is usually 1 day after the execution.
As part of performance on the delivery obligations entailed by the trade, settlement involves the delivery of securities and the corresponding payment.
A number of risks arise for the parties during the settlement interval, which are managed by the process of clearing
Clearing (finance)
In banking and finance, clearing denotes all activities from the time a commitment is made for a transaction until it is settled. Clearing is necessary because the speed of trades is much faster than the cycle time for completing the underlying transaction....
, which follows trading and precedes settlement. Clearing involves modifying those contractual obligations so as to facilitate settlement, often by netting
Netting
In general, netting means to allow a positive value and a negative value to set-off and partially or entirely cancel each other out.In the context of credit risk, there are at least three specific types of netting:...
and novation
Novation
In contract law and business law, novation is the act of either replacing an obligation to perform with a new obligation, or replacing a party to an agreement with a new party...
.
Nature of settlement
Settlement involves the delivery of securities from one party to another. Delivery usually takes place against payment, but some deliveries are made without a corresponding payment (sometimes referred to as a free delivery). Examples of a delivery without payment are the delivery of securities collateral against a loan of securities, and a delivery made pursuant to a margin call.Traditional (physical) settlement
Prior to modern financial market technologies and methods such as depositoriesCentral Securities Depository
A Central Securities Depository is an organization holding securities either in certificated or uncertificated form, to enable book entry transfer of securities. In some cases these organizations also carry out centralized comparison, and transaction processing such as clearing and settlement of...
and securities held in electronic form, securities settlement had involved the physical movement of paper instruments, or certificates and transfer forms. Payment was usually made by paper check
Cheque
A cheque is a document/instrument See the negotiable cow—itself a fictional story—for discussions of cheques written on unusual surfaces. that orders a payment of money from a bank account...
upon receipt by the registrar
Registrar
A registrar is an official keeper of records made in a register. Registrar may also refer to:-Government records:* Recorder of deeds, government office which maintains public records related to real estate...
or transfer agent
Transfer agent
Public companies typically use transfer agents to keep track of the individuals and entities that own their stocks and bonds. Most transfer agents are banks or trust companies, but sometimes a company acts as its own transfer agent....
of properly negotiated certificates and other requisite documents. Physical settlement securities still exist in modern markets today mostly for private (restricted or unregistered) securities as opposed to those of publicly (exchange) traded securities, however payment of money today is typically made via electronic funds transfer
Electronic funds transfer
Electronic funds transfer is the electronic exchange or transfer of money from one account to another, either within a single financial institution or across multiple institutions, through computer-based systems....
(in the U.S., a bank wire transfer
Wire transfer
Wire transfer or credit transfer is a method of electronic funds transfer from one person or institution to another. A wire transfer can be made from one bank account to another bank account or through a transfer of cash at a cash office...
made through the Federal Reserve's Fedwire
Fedwire
Formally known as the Federal Reserve Wire Network, Fedwire is a Real Time Gross Settlement Funds Transfer system operated by the Federal Reserve Banks that enables financial institutions to electronically transfer funds between its more than 9,289 participants...
system). Physical/paper settlement involves higher risks, inasmuch as paper instruments, certificates, and transfer forms are subject to risks electronic media are not more or less such as loss, theft, counterfeit, and forgery (see indirect holding system
Indirect holding system
The indirect holding system is a system of securities clearance, settlement and ownership system most widely used in the world today. It consists of one or more tiers of intermediaries between issuer and investor...
).
The U.S. securities markets experienced what became known as "the paper crunch," as settlement delays threatened to disrupt the operations of the securities markets which led to the formation of electronic settlement via a Central Securities Depository
Central Securities Depository
A Central Securities Depository is an organization holding securities either in certificated or uncertificated form, to enable book entry transfer of securities. In some cases these organizations also carry out centralized comparison, and transaction processing such as clearing and settlement of...
, specifically the Depository Trust Company (DTC
DTC
-Companies and organizations:*Defence Technology Centre*Delaware Theatre Company*Delhi Transport Corporation , the transportation backbone of Delhi*Denver Technological Center, a business park located on I-25 in Denver and Greenwood Village, Colorado...
), and ultimately its parent, the Depository Trust & Clearing Corporation. In the United Kingdom
United Kingdom
The United Kingdom of Great Britain and Northern IrelandIn the United Kingdom and Dependencies, other languages have been officially recognised as legitimate autochthonous languages under the European Charter for Regional or Minority Languages...
, the weakness of paper-based settlement was exposed by a programme of privatisation of nationalised industries in the 1980s, and the Big Bang of 1986
Big Bang (financial markets)
The phrase Big Bang, used in reference to the sudden deregulation of financial markets, was coined to describe measures, including abolition of fixed commission charges and of the distinction between stockjobbers and stockbrokers on the London Stock Exchange and change from open-outcry to...
led to an explosion in the volume of trades, and settlement delays became significant. In the market crash of 1987, many investors sought to limit their losses by selling their securities, but found that the failure of timely settlement left them exposed.
Electronic settlement
The electronic settlement system came about largely as a result of Clearance and Settlement Systems in the World's Securities Markets, a major report in 1989 by the Washington-based think tank, the Group of ThirtyGroup of Thirty
The Group of Thirty, often abbreviated to G30, is an international body of leading financiers and academics which aims to deepen understanding of economic and financial issues and to examine consequences of decisions made in the public and private sectors related to these issues...
. This report made nine recommendations with a view to achieving more efficient settlement. This was followed up in 2003 with a report, Clearing and Settlement: A Plan of Action, with 20 recommendations.
In an electronic settlement system, electronic settlement takes place between participants. If a non-participant wishes to settle its interests, it must do so through a participant acting as a custodian. The interests of participants are recorded by credit entries in securities accounts maintained in their names by the operator of the system. It permits both quick and efficient settlement by removing the need for paperwork, and the simultaneous delivery of securities with the payment of a corresponding cash sum (called delivery versus payment
Delivery versus payment
"Payment at the moment of delivery".Delivery versus payment or DVP is a sale transaction of negotiable securities that can be instructed to a settlement agent using SWIFT Message Type MT 543...
, or DVP) in the agreed upon currency.
Legal significance
After the trade and before settlement, the rights of the purchaser are contractContract
A contract is an agreement entered into by two parties or more with the intention of creating a legal obligation, which may have elements in writing. Contracts can be made orally. The remedy for breach of contract can be "damages" or compensation of money. In equity, the remedy can be specific...
ual and therefore personal
Personal rights
Personal rights are the rights that a person has over their own body. Among personal rights are associated rights to protect and safeguard the body, most obviously protected by the torts of assault and battery...
. Because they are merely personal, their rights are at risk in the event of the insolvency of the vendor. After settlement, the purchaser owns securities and their rights are proprietary. Settlement is the delivery of securities to complete trades. It involves upgrading personal rights into property rights and thus protects market participants from the risk of the default of their counterparties.
Immobilisation and dematerialisation
Immobilisation and dematerialisation are the two broad goals of electronic settlement. Both were identified by the influential report by the Group of Thirty in 1989.Immobilisation
Immobilisation entails the use of securities in paper form and the use of a Central Securities DepositoryCentral Securities Depository
A Central Securities Depository is an organization holding securities either in certificated or uncertificated form, to enable book entry transfer of securities. In some cases these organizations also carry out centralized comparison, and transaction processing such as clearing and settlement of...
or more than one, which is/are electronically linked to a settlement system. Securities (either constituted by paper instruments or represented by paper certificates) are immobilised in the sense that they are held by the depository at all times. In the historic transition from paper-based to electronic practice, immoblisation often serves as a transitional phase prior to dematerialisation.
The Depository Trust Company in New York is the largest immobilizer of securities in the world. Euroclear
Euroclear
Euroclear is a user owned and governed Brussels, Belgium based financial services company that specializes in the settlement of securities transactions as well as the safekeeping and asset servicing of these securities. It was founded in 1968 as part of J.P...
and Clearstream Banking
Clearstream
Clearstream Banking S.A. is the clearing and settlement division of Deutsche Börse, based in Luxembourg and Frankfurt. Clearstream was created in January 2000 through the merger of Cedel International and Deutsche Börse Clearing...
, Luxembourg
Luxembourg
Luxembourg , officially the Grand Duchy of Luxembourg , is a landlocked country in western Europe, bordered by Belgium, France, and Germany. It has two principal regions: the Oesling in the North as part of the Ardennes massif, and the Gutland in the south...
are two important examples of international immobilisation systems. Both originally settled eurobond
Eurobond
A Eurobond is an international bond that is denominated in a currency not native to the country where it is issued. It can be categorised according to the currency in which it is issued. London is one of the centers of the Eurobond market, but Eurobonds may be traded throughout the world - for...
s, but now a wide range of international securities are settled through them including many types of sovereign debt and equity
Stock
The capital stock of a business entity represents the original capital paid into or invested in the business by its founders. It serves as a security for the creditors of a business since it cannot be withdrawn to the detriment of the creditors...
securities.
Dematerialisation
Dematerialisation involves dispensing with paper instruments and certificates altogether. Dematerialised securities exist only in the form of electronic records. The legal impact of dematerialisation differs in relation to bearer and registered securities respectively.Direct and indirect holding systems
In a direct holding systemDirect holding system
The direct holding system is a traditional system of securities clearance, settlement and ownership in which owners of securities had a direct relationship with the issuer...
, participants hold the underlying securities directly. The settlement system does not stand in the chain of ownership, but merely serves as a conduit for communications of participants to issuers.
Regular business days from trade date; dates/terms to settle instruments
| Instrument | Days to Settle in US |
|---|---|
| Stocks | 3 (3 days after trade date or "T + 3") |
| Money Market Mutual Fund | Typically 1 ("T + 1" or "next day"), though can be 0 ("same day") |
| Options | 1 |
It is important to note that, in the U.S., the settlement date/terms for a securities trade is also associated with the character or basis on which the securities trade and settle:
- Regular way (RW) – that is, the normal time frames and manner – example, stocks normally are T+3
- When issued (WI) – short for "when, as, if issued" – signifying a conditional transaction in a security authorized for issue which has not yet been or may never be actually issued. Settlement occurs if and when the security is actually issued and/or the exchange or NASD/FINRA rules that the trades are to be settled. Based on the nature of some securities, sometimes when issued's are never actually issued. For example, US Treasury securities, stock splits and new issues typically trade on a "WI" basis
- Cash – same day settlement, that is, delivery on trade date.
- Delayed delivery – securities are expected to be delivered past normal timeframes/windows. Example, new issue muni's (municipal bonds) often trade on a DD or WI basis (often a month after trade date as disclosed in the note of sale to allow for printing and shipping of the debenture/certificates). Like equities though, muni's can be settled RW, WI or cash, as well as DD or other mutually agreed terms.
- Ex-dividend – the terms of the stock trade are that the price and settlement amount "excludes" a pending dividend declaration (buyers of a stock on or after ex-dividend declaration date but prior to payable date).
- Ex-rights – similar in effect as ex-dividend. A security that trades/settles without any entitlement to a pending rights offering declared on the stock.
See also
- Herstatt risk/settlement riskSettlement riskSettlement risk is the risk that a counterparty does not deliver a security or its value in cash per agreement when the security was traded after the other counterparty or counterparties have already delivered security or cash value per the trade agreement....
- Continuous linked settlementContinuous linked settlementContinuous Linked Settlement is a process by which a number of the world's largest banks manage settlement of foreign exchange amongst themselves . The process is managed by CLS Group Holdings AG and its subsidiary companies and include CLS Bank, a settlement bank regulated by the Federal Reserve...
- CRESTCRESTCREST is the Central Securities Depository for the U.K., Republic of Ireland, Isle of Man and Jersey equities and UK gilts, named after its securities settlement system, CREST. The project was launched in 1993, following the Taurus fiasco, and the company was founded in 1996. CREST allows...
- Subprime mortgage crisisSubprime mortgage crisisThe U.S. subprime mortgage crisis was one of the first indicators of the late-2000s financial crisis, characterized by a rise in subprime mortgage delinquencies and foreclosures, and the resulting decline of securities backed by said mortgages....
- T2S – being developed harmonised settlement platform in Europe