Delivery versus payment settlement is a method used for minimizing risk for both buyers and sellers involved in the securities market. Securities are paper documents or certificates, although more are in electronic form, that demonstrate an investor’s portion of ownership in a publicly traded company (stocks) or debt obligation (bonds). Delivery versus payment (DVP) is the safest way to settle the sale or purchase of securities.
Delivery versus Payment
Delivery versus payment, also known as cash on delivery, allows a seller of securities to make immediate delivery of the purchased securities to the buyer. Typically, the securities are delivered to a bank or other financial institution, acting as an agent on behalf of the buyer. The buyer’s payment is concurrently made by way of check, bank wire or direct credit to the seller’s account. If delivery and payment do not occur simultaneously, there is greater risk of theft by either party. The DVP process renders the securities transaction final, with book entries as evidence of both parties’ mutual commitment to complete the deal.
The clearance and settlement of securities occurs during what is known as the settlement process. It is during this process that securities transactions are completed, by the final transfer of the securities to the buyer from the seller (delivery) and transfer of funds to the seller from the buyer (payment). The highest amount of risk for both seller and buyer is represented during the settlement process, at which time either party could default on the transaction. Without a delivery versus payment settlement system in place, there is added risk that the buyer will pay but fail to receive delivery of the securities, or the seller may deliver said securities but not receive payment.
The settlement date of a securities transaction is the date on which the buyer must pay the seller. The settlement date is usually dependent on the type of security being traded. Typically, the settlement date for stocks is three days after the trade took place, whereas, the settlement date for bonds is the next trading day. Even with a delivery versus payment settlement system, there is a certain amount of credit risk involved that one party or the other will fail to complete the transaction by the settlement date. A securities transaction with a settlement date of more than 45 days beyond the trade date is not considered to be a DVP transaction.
Replacement Cost and Liquidity Risk
Both buyer and seller face a replacement cost risk, if either party defaults on the transaction. The replacement cost risk is the potential loss of unrealized gains on a given security contract. Unrealized gains are established by comparing the security’s market price at the time of default, with the contract price. The buyer’s risk is higher if the market price is above the contract price, and the seller’s risk is higher if the market price is below the contract price. When either party defaults on the transaction, both buyer and seller have increased liquidity risk as well. Liquidity risk for the seller involves the potential need to borrow or liquidate other assets when payment is not received. For the buyer, it means the potential need to borrow the security to complete delivery obligations, when the seller fails to deliver the purchased security.