Trade Settlement: Key Terms and Processes Explained

Trade settlement is the final step in the trading process. It’s the transfer of ownership of securities or financial assets from the seller to the buyer after a trade is executed. This article breaks down the key terms and processes involved, as well as regulatory frameworks and industry standards.

Explaining trade settlement

Trade settlement is the process that follows the execution of a securities transaction, where the buyer receives the purchased securities and the seller is paid. The settlement process is regulated to reduce market risk and ensure market stability. Delays in settlement can impact liquidity, market stability and the functioning of financial markets. Most securities transactions, including equities, bonds and other financial instruments are governed by strict rules to ensure timely exchange of assets.

Post-trade processing occurs to validate trade details, compare and approve the transaction and finalise ownership changes. In the US, trade settlements follow the rules set by the Securities and Exchange Commission (SEC) and the Financial Industry Regulatory Authority (FINRA).

Why is trade settlement important in financial markets?

• It ensures the exchange of funds and assets.
• Timely settlement reduces counterparty risk, so all parties fulfill their obligations.
• Delays in settlement can lead to market instability and increase financial risk.

Trade settlement period

The settlement period is the time between the transaction date (when the trade is executed) and the settlement date (when the transfer of assets and funds is completed). The settlement period varies depending on the asset class, market and local regulations. For example, US equities follow a T+1 settlement cycle, which means settlement occurs one business day after the trade date. Municipal securities, foreign exchange (FX) transactions and certain mutual funds may follow different settlement cycles.

What’s the impact of settlement periods on liquidity and risk?

• Shorter settlement cycles like T+1 reduces the window of exposure to market risk, where price volatility can affect the value of assets during the settlement period.
• Delays or errors in settlement can lead to operational risk, such as incorrect account statements or unfulfilled asset transfers.

Settlement date and cycle

The settlement date is when ownership of securities changes hands. For regular-way trade (RW) transactions, this follows the standard settlement cycle which depends on the asset. For example:

• Equities and exchange-traded funds (ETFs) usually settle in a T+1 cycle.
• Government securities and spot foreign exchange (FX) may follow shorter cycles, such as same-day settlement. The SEC shortened the settlement cycle for most securities transactions to T+1 as of May 28, 2024, as post-trade processing has improved and credit risk has reduced. How are settlement cycles evolving?
• The move from T+2 to T+1 in 2024 reduced market exposure, operational risk and improved efficiency for financial institutions.
• Industry is pushing for further reduction in settlement period to improve market resilience.

Futures settlement and futures settlement price

In the case of futures contracts, the settlement process is slightly different from securities transactions. Futures contracts can be cash-settled or require physical delivery of the underlying asset.

• Cash settlement involves determining a futures settlement price which reflects the market value of the asset at the close of the trading period.
• Physical settlement requires the delivery of the asset specified in the contract. The futures settlement price is calculated daily to mark the contract to market. This is important for risk management and financial reporting. What are the main types of futures settlement methods?
• Cash settlement: No physical asset is delivered and the contract is settled based on its market value.
• Physical settlement: The asset underlying the contract is delivered to fulfill the agreement.

Benefits of shorter settlement cycles (T+1)

Shortening the settlement cycle to T+1 has several benefits for financial institutions and investors:

• Reduced counterparty risk: A shorter settlement period minimizes the time between trade execution and settlement, reducing the risk of non-completion due to price volatility or liquidity issues.
• Improved liquidity: Investors can access their funds or securities faster, making markets more efficient.
• Regulatory alignment: The move to a T+1 settlement cycle in 2024 aligns with global regulatory efforts to modernise financial markets and reduce risk.

Why is the T+1 settlement cycle important?

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• It improves liquidity and reduces counterparty risk by closing transactions faster.
• The adoption of shorter cycles is part of a broader trend to make financial markets more efficient and resilient.

Clearance and settlement in financial markets

Clearance and settlement are the processes that finalise a trade by matching and confirming trade details between two broker-dealers before the transfer of funds and assets occurs. The clearing process ensures that both the buyer and seller agree on the terms of the transaction, including price, quantity and time of execution. After clearing, the settlement process completes the transfer of ownership and payment. Financial institutions, clearinghouses and regulators play a crucial role in ensuring the accuracy, timeliness and security of the settlement process.

What’s the difference between clearance and settlement?

Clearance involves reconciling the details of a trade to ensure agreement between the buyer and seller.

Settlement is the final step where the actual transfer of assets and funds takes place. Efficient clearance and settlement is key to the smooth functioning of financial markets, reducing the risk of defaults and ensuring market stability.

Conclusion

Trade settlement is critical to the stability and efficiency of financial markets. The move to shorter settlement cycles, such as the T+1 cycle, reflects the financial industry’s efforts to modernise and reduce risk in securities transactions. By understanding key terms like settlement period, settlement date and futures settlement, you can navigate the post-trade processing with confidence.