Settlement in Finance

Settlement is essentially the completion of the transaction.

I tell my CFA tutoring in London students that there are several reasons why settlement is not instant in institutional transactions.

The first is just processing time. It takes time to process a trade and match all the documents and instructions. In the past that may have been due to the extent of the manual input, which is much rarer (although not completely gone) these days. So the trade is finalised when both parties can be sure of having processed the trade.

Second is operational error. There may be some error in the trade such amount, size, direction or even asset. To allow time to cancel a trader (on a mutually agreed basis) both parties have a window between agreeing a trade and settling a trade.

The third is credit risk. Herstatt risk is when there is a risk that one side of the party will not be honour its agreement, perhaps because it doesn’t exist any more. In 1970s the German Bankhaus Herstatt was closed by the authorities due to balance sheet issues. However it still has not completed some foreign exchange transactions with Citigroup so they didn’t get their side of the transaction. It was estimated that around $200m was lost in that actions. So now institutional FX transactions are settled T+2 (that is trade date + 2 business days). That means that the monies are only transferred by the clearing bank 2 days after the agreement date, i.e. when both parties have paid their amounts into the clearing bank. I explain this in my finance executive coaching in London.

CLS or continuously linked settlement has largely eliminated Herstatt risk but, for the sake of history and convention FX trades tend to still be settled T+2.

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