Understanding Trade Settlement, Its Meaning, Types and Violation

Summary:

Trade settlement is a two-way process wherein the buyer gets the stocks purchased, whereas the seller receives money for selling the stocks. That said, the actual transfer of ownership occurs on the settlement date, which typically happens on a T+1 basis.

In the stock market parlance, one of the terms you will frequently encounter is trade settlement. So, what exactly does this term mean, and what’s its importance for you as an investor? Let’s find out.

What is trade settlement?

Trade settlement refers to the process wherein buyers get the purchased stocks, and the seller gets the money. The trade is said to be settled once the buyer gets the stocks and the seller receives the money for selling those stocks. The actual transfer of ownership occurs on the settlement date, represented by the letter ‘T’ plus the number of days for the settlement to occur.

Indian share markets have migrated to a T+1 settlement date from the earlier T+2, which means settlements happen one day after the transaction. So, if the trade is executed on Monday, the settlement happens on Tuesday, provided it’s not a holiday.

Types of trade settlement

Now that you know the meaning of trade settlement, let’s understand the various settlement types that happen in stock markets. Basically, there are two types of trade settlement, namely:

1. Spot settlement: Spot settlement, as the name suggests, refers to the settlement type that happens almost immediately after the execution of trade. It generally occurs within 1 to 2 business days from the trade date. Its key characteristics include:

• Rapid execution usually within a short-period
• Minimal market risk as prompt execution ensures trade is settled without significant price fluctuation
• Gives you immediate control and right over the stock

1. Forward trade settlement: This type of trade settlement happens when both the buyer and seller agree to settle the trade at a future date, which could be 5 or 7 days after the execution of trade. This type of trade settlement is usually prevalent in the derivatives market. Key trait of forward trade settlement include:

• Customisation as both parties can tailor the settlement date as per their requirements

Parties involved in trade settlement

There are several parties involved in a trade settlement. These include:

• Clearing corporation

A clearing corporation acts as an intermediary between buyers and sellers. Its responsibilities include clearing trade and risk management by ensuring that securities and funds are transferred correctly. In India, the National Securities Clearing Corporation Limited (NSCCL) is in charge of clearing and settling trades.

• Clearing member

Clearing members are brokerage houses facilitating the trade settlement process on your behalf. They are responsible for submitting trade details and ensuring compliance with regulatory requirements.

• Clearing banks

Clearing banks are the key link between clearing members and the clearing corporation in the movement of funds. They handle financial transactions such as electronic fund transfers. Every clearing member must open a dedicated clearing account with a designated clearing bank.

The trade settlement process

Here’s an overview of the trade settlement process:

• After the execution of the trade, on the T day, the clearing corporation gets the specifics of the transaction from stock exchanges
• The clearing corporation then gets confirmation from clearing members before closing the trade
• Once the transaction details are confirmed, clearing banks ensure that there are sufficient funds, and brokerage houses make the shares available
• The clearing corporation receives funds and securities from clearing banks and brokerage houses for purchase and sale and settles the trade

Settlement violation

In some cases, settlement violations may occur. It happens when the purchase of stocks is successfully executed, but there is insufficient money in the investor's account to cover the cost of trade on the settlement day.

When it happens, the responsibility to settle falls upon the brokerage house. One common way to do it is to sell the stock, effectively cancelling the trade. It aims to prevent further losses if the stock's market value has changed unfavourably.

In such a situation, brokerage houses may also charge you a penalty for any losses incurred due to trade cancellation, typically the difference between the stock's original purchase price and the price at which it was sold.

In addition to penalties, you might also need to pay interest to the brokerage firm due to settlement violations. That said, some brokerage firms offer margin accounts that allow you to borrow money to manage the shortfall.

Summing it up

Digitalisation has made trade settlement quicker and a hassle-free exercise. All you need to ensure is that you have enough funds in your account on the settlement day to avoid violations. Happy trading!