Interested in The Trade Life Cycle?
From the point a securities order is placed in a digital channel, there are several operations applied on the order and these operations depend on the asset you are trading...
This paper will walk through the operations after the securities are placed in the digital channels.
The objective of the post-trade stage is to complete the exchange of the asset and cash for orders that have completed the trade stage.
The key activities in the Post-Trade stage are: "Matching", "Confirmation", "Settlement and Clearing". In this Article, we will be sharing about Settlement and Clearing.
Settlement and Clearing
Settlement is the process of exchanging securities and cash. After the buy side and the sell side are legally bound to order and both parties confirm the order details are correct, they can exchange the securities and cash, i.e. the settlement process.
There are two types of settlement processes. The majority is DvP (Delivery versus Payment) which means the exchange of securities and cash is carried out simultaneously. This type minimizes the settlement risk. The minority is FoP (Free of Payment) which means delivering securities or cash before the receiving of cash or securities. FoP is usually used with the credit facility and is mainly for institutional clients.
The settlement process is not carried out by the buy side and the sell side, it is carried out by the custodian and clearing house. Custodian is one of the parties in the trade process. Its responsibility is to keep the securities for the clients, e.g. banks, brokers, dealers, or individual clients. Clearing houses are official organizations in the financial market. For instance, official clearing houses in Singapore are MAS and Central Depository Pte Ltd (CDP) are the official clearing house, the official clearing houses in Hong Kong are Hong Kong Securities Clearing Company Limited (HKSCC), HKFE Clearing Corporation Limited (HKCC), The SEHK Options Clearing House Limited (SEOCH) and OTC Clearing Hong Kong Limited (OTC Clear).
Custodian will take settlement instructions from the sell side to send securities to the clearing house and ask the clearing house to deposit cash into its client’s Nostro accounts in the clearing house. On the other hand, it will take settlement instructions from the buy side to ask for the clearing house to release funds from its clients’ Nostro accounts in the clearing house and collect securities from the clearing house.
Nostro accounts refer to cash accounts in different currencies and held by the clearing house in the name of the trading parties. When the trading parties engage with a clearing house, these Nostro accounts will be set up. They are used for cash deposits and release in the settlement and clearing process.
< Figure 1: Flow of Securities Settlement >
The settlement instructions are in the format of an electronic message. A widely used message format is SWIFT which is well accepted by most of the clearing houses. Among the messages from SWIFT, there are seven messages used in the settlement process.
Depending on the asset class, the settlement process could be far more complicated than ordinary securities. For example, Equity Linked Note (one of the derivatives) involves the transfer of cash and a contract followed by multiple settlements that only involve cash transfer.
Because there are so many processes needed to be taken, that take time to complete. The financial market regulators have set a standard of the maximum number of business days from the completion of the trade stage to the completion of settlement and clearing. In Singapore, Hong Kong, and the USA, the standard is 2 days and is referred to as settlement day and is expressed in “T+2” (Trade Date plus 2 business days). In China, the settlement day is T+0 which means the settlement has to be completed on the same day of the trade.
With the improvement of technology and STP, the market trend is to reduce the settlement day. This is because the longer the settlement day, the higher the risk of the settlement.
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