Trade Settlement

What is Trade Settlement? 

Trade settlement refers to the day money is exchanged by the buyer and seller in a transaction. 

Trade settlement does not confer risk; that is assumed at the time of the trade. Trade settlement allows time for paperwork between the exchange, the brokers and the investor to be completed. Trade transfers are handled by 'back office operations' offices that employ pre-trade and post-trade operators to quickly process transactions.The concept of trade settlement has important consequences for investors and investment traders. When an investor buys or sells a security, the trade is not complete until it has settled.

Settlement involves the delivery of funds or 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). 

Who ensures the settlement? 

The stock exchange ensures that buyers who have paid for the shares purchased receive the shares. Similarly, sellers who have delivered the shares receive payment for the same.

The entire process of settlement of shares and money is managed by stock exchanges through the clearing house. The clearing house has been formed specifically to facilitate the transfer and ownership of shares and ensure the process of settlement takes place smoothly.

Settlement Period

• The period of time between the settlement date and the transaction date that is allotted to the parties of a transaction to satisfy the transaction's obligations. The buyer must make payment within the settlement period, while the seller must deliver the purchased security within this period.

• Rolling Settlement
• In a rolling settlement, each trading day is considered as a trading period and trades executed during the day are settled based on the net outstanding/obligations. At present, trades in rolling settlement are settled on a T+2 basis, ie on the second working day. 
• For instance, trades taking place on Monday are settled on Wednesday, Tuesday's trades settled on Thursday and so on.T+2 means that trades are settled two working days after the day the trade takes place.
• The Securities and Exchange Board of India (SEBI) introduced the T+5 rolling settlement in the equity market in July 2001 and subsequently shortened the settlement cycle to T+3 in April 2002. After having gained experience from the T+3 rolling settlement and realizing more risks, SEBI further reduced the settlement cycle to T+2, hoping to reduce the risk in the market and protect the interest of investors. 
• For arriving at the settlement day, all intervening holidays -- bank holidays, National Stock Exchange holidays, Saturdays and Sundays -- are excluded. 

What is Rolling Settlement Cycle?

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• The period within which the settlement is made- the period within which buyers receive their shares and sellers receive their money -- is called a Settlement Cycle. The time schedule prescribed by the Securities and Exchange Board of India, the market watchdog, for implementation of T+2 rolling settlements, beginning from April 1, 2003, is as follows:
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• T= Trade Day
• T+1 Day - 

• Confirmation of trades by custodians latest by 11 am on T+1. A provision of an exception window would be available for late confirmations. The time limit and the additional charges for the exception window would be decided by the exchanges.
• The exchanges / clearing house / clearing corporation would process and download the obligation files to the brokers' terminals latest by 1.30 pm on T+1.
• T+2 Day - 

The depository would permit the downloading of the pay-in files of securities and funds till 10.30 am on T+2 from the broker pool accounts. 

The depository would process the pay-in requests and transfer the consolidated pay-in files to the clearing house / clearing corporation by 11 am on T+2. 

The exchanges / clearing house / clearing corporation would execute the pay-out of securities and funds latest by 1.30 pm on T+2 to the depositories & clearing banks & the depositories & the clearing banks would in turn complete the process by 2 pm on T+2. 

Simply speaking, if we sell shares, the money is received by your broker on the third day. If we buy shares, your broker gets them on the third day.

What is Pay-In and Pay-Out ?

In Pay-in of securities all the shares' obligations are picked up from the client's beneficiary account and transferred to Broker pool account. All the shares are then delivered to the clearing corporation as per obligation with Exchanges.

In Pay-in of funds , the funds are transferred from a client's bank account to Broker bank account. All the funds are then transferred to the clearing corporation as per obligation.


In Pay-out of securities, shares are received from the Clearing corporation and the same is transferred to Broker pool account. All the shares are then transferred to the client beneficiary account.

In Pay-out of funds, funds are transferred from the Clearing corporation to Broker Bank a/c. All the funds are then transferred to the client bank a/c.

At present, the pay-in and pay-out happens on the 2nd working day after the trade is executed on the exchange, that is settlement cycle is on T+2 rolling settlement.

Advantages of Rolling Settlements compared to Weekly Settlements - 

Since in the Rolling Settlements, trades are settled earlier than the the Account Period settlement, the settlement risk is much lower. The reason is that in weekly settlements, the trade is consolidated, netted and settled on a single day. This resulted in higher deliveries to be settled for the trades done during the week. Since in Rolling Settlements, trades on a particular day are settled separately from the trades done on any other day, the settlement risk is considerably reduced. Moreover, the sellers and buyers get the monies and securities for their sale and purchase transactions respectively earlier than in Account Period settlements. This also achieves international best practice for settling trades.

In rolling settlements, payments are quicker than in weekly settlements. Thus, investors benefit from increased liquidity. From an investor's perspective, rolling settlement reduces delays. This also reduces the tendency for price trends to get over valued. Hence, investors not only get a better price but can also act at their leisure. Currently in India, in the weekly settlement cycle, sale proceeds of transactions done on the first trading day are available on the 12th day and on the eighth day, if the trade takes place on the last day of the trading cycle.

The National Stock Exchange was the first to introduce rolling settlements in the country. Rolling settlements require electronic transfers of funds and demat facilities, with respect to securities being traded. 

Trade Settlement Risk 

The risk that is being conferred when one party fails to deliver the terms of a contract with another party at the time of settlement Date. Settlement risk can be the risk associated with default at settlement and any timing differences in settlement between the two parties. This type of risk can lead to principal risk.

Settlement risk is sometimes called "Herstatt risk", named after the well-known failure of the German bank Herstatt. On Jun 26, 1974, the bank had taken in its foreign-currency receipts in Europe, but had not made any of its U.S. dollar payments when German banking regulators closed the bank down, leaving counter parties with the substantial losses.


Mitigating Trade Settlement Risk 

In order to mitigate the risks  that Trade Settlement confers and bring financial stability, there has been few strategies being used to counter those risks. These are as follows - 

• Delivery versus payment - A common form of settlement for securities. A DVP settlement system ensures that delivery will occur only if a payment occurs. The system acts as a link between a funds transfer system and a securities transfer system . The system helps ensure that payments accompany deliveries, thereby reducing principal risk, reducing the chance that deliveries or payments would be withheld during periods of stress in the financial markets and reducing liquidity risk.

• Settlement via clearing houses - A clearing house is a financial institution that provides clearing and settlement services for financial and commodities derivatives and securities transactions. A clearing house stands between two clearing firms (also known as member firms or clearing participants) and its purpose is to reduce the risk of one (or more) clearing firm failing to honor its trade settlement obligations. 

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