In the post-trade process, arguably the most important segment is the clearing and settlement of the transaction. While clearing refers to the actions between the trade date and the settlement date, the transaction settlement is a key date in both the buyer’s and seller’s financial reporting system. It is on the settlement date that the actual ownership transfers from the seller to the buyer and depending on the accounting system, that is the first official day from which any income, profits, expenses or losses relating to the transaction are booked in the buyer’s records. The actual process is pretty simple in principle: the seller hands over its securities to the broker-dealer who distributes it to the buying party/parties involved and the buyer wires the money required to pay for the actual securities. Most transactions are settled on a T+3 basis i.e. 3 business days after the trade date. Most corporate securities including stocks and fixed income bonds are settled on a T+3 basis, however U.S. Treasury securities (T-Bills) are settled on a T+1 basis. A smaller minority of trades are even settled on a same day basis. These are known as cash trades.
While transaction settlements have always been around since the time of public markets, the complexion of these settlements has changed to newer, faster platforms. Most transactions in North America, Europe and Asia are done through the Deliver versus Payment electronic system where simultaneous exchanges of cash and securities are completed, so as to protect both the buyer and seller from a potential fraud risk. In some cases, there is also a Delivery versus Free system implemented, although these are largely used for the posting of collateral or to add necessitated funds for a margin call. Before the electronic platform was implemented, these settlements were pure paperwork wherein payments were handled by cheque and share certificates would be given to the clients once the check was received. While this method isn’t completely extinct today, it is rare to find paper transactions in the public markets. Generally, they are reserved for the private markets where there are no formal share certificates issued. The problem with this type of transaction settlement however, was that the markets experienced a “paper crunch” which led to delays and disrupted operations. As trading volumes increased sharply after 1986, these delays carried far more gravity than previously, leading to the formation of an electronics settlement platform – currently called the Depository Trust & Clearing Corporation.
The electronic settlement is a platform where participants can conduct transactions with each other across geographies in almost real time. If a non-participant is looking to settle a transaction, there is generally a requirement for a third party to act as the custodian. As mentioned previously, the main advantages of an electronic system include a simultaneous exchange of assets and securities that offer an added layer of protection. But in today’s markets, there is another advantage that many would argue is equally important as the safety aspect. This factor is time. With the electronic system, there are ample opportunities for time savings to be achieved as labour requirements are diminished and automated processes execute each transaction.
One last consideration to make about the transaction settlement process is the legal aspect. After the trade is made and before the settlement is done i.e. before the ownership is transferred, the right of the purchaser are only contractual with respect to the transaction details and therefore, non-binding in the case of a seller default in the period between the trade date and settlement date. Once the ownership is transferred on the settlement date, the borrower’s rights are upgraded to proprietary rights meaning that there is now a level of protection added that insulates the borrower from counterparty risk of default. All in all, while the transaction settlement process has been upgraded from the paper system to a more robust electronic payment system, there still remains some margin for improvement in shaving the time gap between the trade date and settlement date for corporate securities.