Definition
Settlement is the final stage of a securities transaction where the buyer receives the securities and the seller receives cash. The settlement cycle is denoted by "T+" where "T" is the Trade Date.
- T+2: Settlement occurs 2 business days after the trade date (e.g., trade on Monday, settles on Wednesday). This was the historical standard.
- T+1: Settlement occurs 1 business day after the trade date (e.g., trade on Monday, settles on Tuesday). This is the new standard in the U.S. (since May 2024) and India.
- T+0: Same-day settlement, which is rare for equities but common in crypto or some FX trades.
Why It Matters: Shorter settlement cycles reduce counterparty risk and collateral requirements but demand more efficient operational infrastructure.
Definition
A CCP is a financial institution that interposes itself between the buyer and seller of a trade. Through a process called novation, the CCP becomes the buyer to every seller and the seller to every buyer, thereby guaranteeing the settlement of the trade.
Mechanism (Novation)
After a trade is executed, the original contract between the buyer and seller is replaced by two new contracts: one between the buyer and the CCP, and one between the seller and the CCP. The CCP manages risk by collecting initial and variation margin from both parties.
Example
Investor A buys 1,000 shares of Apple from Investor B. A CCP (like the OCC in the U.S.) steps in. Investor A's obligation is now to the CCP, not Investor B. The CCP guarantees that A will receive the shares and B will receive the cash, even if one party defaults.
Clearing House
A clearing house is responsible for the pre-settlement processes, including trade matching, affirmation, netting of obligations (cash and securities), margin collection, and overall risk management. Examples include LCH and ICE Clear.
Central Securities Depository (CSD)
A CSD is an entity that holds securities in electronic (dematerialized) form and facilitates their transfer during settlement. Examples include DTCC (U.S.), Euroclear, and Clearstream.
Mechanism
After the clearing house calculates the net obligations, it instructs the CSD to perform the final settlement. The CSD updates its books by debiting the seller's account and crediting the buyer's account with the securities, typically on a Delivery vs. Payment (DvP) basis.
Key Point: Clearing is the process of calculating obligations. Settlement is the process of fulfilling them. The CSD is the venue where the securities are held and moved.
Definitions
- Custodian Banks: Large financial institutions (e.g., BNY Mellon, State Street) that safekeep securities on behalf of investors. They also handle administrative tasks like corporate actions, income collection, and reporting.
- Sub-Custodians: Local banks in foreign markets that act on behalf of global custodians to manage local settlement and regulatory compliance.
Account Structures
- Omnibus Account: Multiple clients’ securities are pooled together in one account held by the custodian. It is efficient but less transparent.
- Segregated Account: Each client’s holdings are kept in a separate account, offering full transparency at a higher cost.
Example
A UK pension fund buys Indian equities. Its global custodian (e.g., Citi) will use a local sub-custodian in India (e.g., HDFC Bank) to hold the securities and manage settlement on the ground.
Securities Lending
The temporary transfer of securities from a lender (e.g., a pension fund) to a borrower (e.g., a hedge fund), often to facilitate short selling. The borrower posts collateral and pays a lending fee.
Repo (Repurchase Agreement)
Effectively a collateralized short-term loan. One party sells securities to another with an agreement to repurchase them at a later date at a slightly higher price. The price difference represents the interest on the loan.
Example (Repo)
A bank sells $10 million of bonds to another bank and agrees to repurchase them in one week for $10.01 million. The $10,000 difference is the implied interest on the one-week loan.
Settlement Fails
This occurs when securities or cash are not delivered on the scheduled settlement date due to operational errors, counterparty default, or an inability to borrow stock for a short sale.
Buy-Ins
If a seller fails to deliver securities, the buyer’s broker has the right to "buy-in" the securities from the open market to complete the trade. Any price difference is charged back to the failing seller.
Corporate Action Processing
Custodians and CSDs are responsible for processing corporate actions on behalf of investors, such as distributing dividends, managing rights issues, and handling stock splits or mergers.
Purpose
These unique codes are used to accurately identify securities globally, which is essential for error-free clearing and settlement.
| Identifier | Full Form | Region / Use |
|---|---|---|
| ISIN | International Securities Identification Number | Global standard (e.g., US0378331005 for Apple Inc.) |
| CUSIP | Committee on Uniform Securities Identification Procedures | U.S. & Canada (e.g., 037833100) |
| SEDOL | Stock Exchange Daily Official List | United Kingdom |
Post-Trade Workflow Summary
| Stage | Process | Entity Involved |
|---|---|---|
| Trade Execution | Order placed and matched | Exchange / Matching Engine |
| Clearing | Net obligations calculated | Clearing House (e.g., OCC) |
| Settlement | Delivery vs. Payment (DvP) | CSD (e.g., DTCC) |
| Custody | Assets safekept and serviced | Custodian Bank |
| Securities Lending | Securities temporarily transferred | Custodian / Prime Broker |
Final Interview Tips
Be ready to explain the T+1 settlement cycle, the difference between clearing and settlement, the crucial role of a CCP in reducing risk, and the functions of a custodian. Settlement fails and buy-ins are common topics in operations interviews.