Transaction Settlement – Delivery vs. Payment

In the transaction settlement process, the delivery vs. payment (DVP) is an extremely common form of settlement of securities between the two trading parties

Transaction Settlement – Delivery vs. Payment

In the transaction settlement process, the delivery vs. payment (DVP) is an extremely common form of settlement of securities between the two trading parties

RECEP KARACA
RECEP KARACA
22 Kasım 2017 Çarşamba 14:25
128 Reads
Transaction Settlement – Delivery vs. Payment

In the transaction settlement process, the delivery vs. payment (DVP) is an extremely common form of settlement of securities between the two trading parties. The DVP settlement is from the buyer’s perspective – from the seller’s perspective, it is RVP (receipt vs. payment). What the DVP stipulates is that the entire process involves the cash payment be made prior or simultaneously as the date of the delivery. The entire process came about to be from a regulation that prohibited the payment of a security prior to being held in a legally binding form. This was done largely to prevent settlement risk between parties where one party receives the security without paying for it.

When talking about credit risk, it is important to understand that a large portion of credit risk during the security settlement process is the misalignment of the principal payment date and the settlement date. Therefore, the DVP/RVP system was conceptualized which looked to eliminate the lead time between the payment and delivery dates, consequently reducing credit risk as well. However, there are flow-down effects as well because the system ensures that payments and deliveries go together, reducing the probability of deliveries or payments being held back in periods of high financial stress in the markets. When these payments are made on time and deliveries are made to be accompanying these payments, liquidity risk is reduced in the overall financial markets and market players can then conduct daily transactions in good faith with a reasonable degree of confidence.

When the DVP was conceptualized, it was made to be a law where an asset of equivalent value as the securities being transferred had to be paid by the buying party. The delivery of securities is normally made to the bank of the buyer while the payment is received through a direct credit or wire transfer. In 1987, when equity prices dropped worldwide, there was an enormous problem of date misalignments as buyers held back their payments to sellers, thus causing sellers to be short of securities inventory while buyers were hesitant to make scheduled payments fearing a liquidity shortage. This incident prompted the central banks of the largest economies in the world to devise the DVP/RVP transaction settlement procedure.

Another form of settlement includes the non-DVP payment which does expose the two parties to an element of settlement risk. These transaction settlements are often called free of payment, free delivery etc. What they entail is a transfer of securities without an equal transfer of funds in value. The funds’ terms are generally agreed upon mutually through another binding agreement and in rare cases, payment may not be made at all. This is especially done in the cases where securities are being gifted or inherited. The DVP/RVP method certainly has its advantages over this form however, particularly in stressed markets. When there is low confidence by market players over the health of the markets, these players tend to turn conservative looking more at a capital preservation approach than a capital growth approach. In these scenarios, it is unwise to conduct trade settlements on a non-DVP basis as it exposes the seller and in some cases, the buyer to an undesirable amount of credit risk. Instead, the DVP method would then align the interests of the seller and the buyer and in the case of one party not honouring their end of the commitment, there can be an immediate halt in trading operations before the appropriate trade settlement procedures are undertaken.

In the months after the 1987 equity market collapse and the overhaul settlement regulations, markets calmed down significantly, but settlement procedures were changed forever and for the better. Parties could now operate in good faith with less risk of default or non-repayment. That boded well for the overall health of the financial markets as well as it attracted more participants, thus increasing liquidity and created more capital generation opportunities.

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