What is clearing and settlement?
What follows a trade is called clearing and settlement. Clearing is what comes immediately after the trade. All the terms of the deal are double checked, reconciled, and confirmed.
Settlement is the final fulfilment of a securities transaction - the actual transfer of securities and money. Ownership of the securities is transferred and the buyer takes delivery against payment to the seller.
What are the terms of a trade that are double checked in clearing?
These terms includes:
- The exact identity and trading entity of both the buyer and seller
- The exact security
- The quantity
- The price amount of cash to be transferred
- The date intended for settlement
- The accounts and instructions for both the delivery of the securities and the cash
How is the clearing process made to be more efficient?
- Netting
- Efficiency can be achieved by “netting” if counterparties have more than one trade in the same security. Instead of sending payments and securities for each transaction, trades and payments can be aggregated and settled by transferring the net difference in securities and funds.
- Accuracy
- It is important to avoid any errors in the clearing process. If any one of the terms is not agreed properly and don’t match, the trade will not settle.
What is “Delivery versus payment”?
“Delivery versus payment” (DVP) is an important concept in settlement. DVP stipulates that cash payment and delivery of the security occur simultaneously, so that both buyer and seller are protected against default. Trades not settling DVP are subject to what is called “Herstatt Risk”, named after a small German bank that failed in 1974.
When does settlement take place?
Settlement takes place on a “T plus” basis - that is, trade date + a given number of days. For example, a T+ 2 trade settles two days after the trade.
