The Settlement Cycle - What is settlement?

After you have bought or sold shares through your broker, the trade has to be settled. Meaning, the buyer has to receive his shares and the seller has to deliver the shares and receive his money. At the end of this settlement cycle period, the obligations of each broker are calculated and the brokers then settle their respective obligations according to the guidelines, laws and regulations institutionalized by the Clearing agency

Pay-In is a process where by a stock broker and Custodian (in case of Institutional deals) brings in money and/or securities to the Clearing House. This forms the first phase of the settlement activity

Pay-Out is a process where Clearing House pays money or delivers securities to the brokers and Custodians. This is the second phase of the settlement activity

The whole set of money transaction is performed by a bank in the Stock Exchange premises. Exchange appoints this bank to handle the money part of the transaction.

As an example the settlement cycle and the process involved in the settlement at NSE - National Stock Exchange - of india is described here.

The settlement cycle in India is T+2 days i.e. Trade + 2 days. T+2 means the transactions done on the Trade day, will be settled by exchange of money and securities on the second business day (excluding Saturday, Sundays, Bank and Exchange Trading Holidays). Pay-in and Pay-out for securities settlement is done on a T+2 basis.

The following is the summary of trading and settlement process in India.

• Investors place orders from their trading terminals.
• Broker houses validate the orders and routes them to the exchange (BSE or NSE depending on the client’s choice) Order matching at the exchange.
• Trade confirmation to the investors through the brokers.
• Trade details are sent to Clearing Corporation from the Exchange.
• Clearing Corporation notifies the trade details to clearing Members/Custodians who confirm back. Based on the confirmation, Clearing Corporation determines obligations.
• Download of obligation and pay-in advice of funds/securities by Clearing Corporation.
• Clearing Corporation gives instructions to clearing banks to make funds available by pay-in time.
• Clearing Corporation gives instructions to depositories to make securities available by pay-in-time.
• Pay-in of securities: Clearing Corporation advises depository to debit pool account of custodians/Clearing members and credit its (Clearing Corporation’s) account and depository does the same.
• Pay-in of funds: Clearing Corporation advises Clearing Banks to debit account of Custodians/Clearing members and credit its account and clearing bank does the same.
• Payout of securities: Clearing Corporation advises depository to credit pool accounts of custodians/Clearing members and debit its account and depository does the same.
• Payout of funds: Clearing Corporation advises Clearing Banks to credit account of custodians/ Clearing members and debit its account and clearing bank does the same. Note: Clearing members for buy order and sell order are different and Clearing Corporation acts as a link here.
• Depository informs custodians/Clearing members through Depository Participants about pay-in and pay-out of securities.
• Clearing Banks inform custodians/Clearing members about pay-in and pay-out of funds.
• In case of buy order by normal investors Clearing members instruct his DP to credit the client’s account and debit its account. The money will be debited (Total settled amount – margins paid at the time of trade) from the client’s account.
• In case of sell order by normal investors Clearing members instruct his DP to debit the client’s account and credit its account. The money will be credited to the client’s account.

In case of trades by mutual fund houses the custodians act as clearing members.

All the above information is mostly in relation to the Indian Stock market. Sometimes in different countries processes may have some deviation from it, but the basic fundamentals behind the whole process remains same. In India, the Pay-in of securities and funds happens on T+ 2 by 11 AM, and Pay-out of securities and funds happen on T+2 by 3 PM.

Who ensures the settlement?

The stock exchange ensures that buyers who have paid for the shares purchased receive the shares. Similarly, sellers who have delivered the shares receive payment for the same. The entire process of settlement of shares and money is managed by stock exchanges through the clearing house. The clearing house has been formed specifically to facilitate the transfer and ownership of shares and ensure the process of settlement takes place smoo

Auction

An auction is resorted to when there is a default in delivery by a broker. An auction is the exchange’s mechanism through which, in a settlement, a buyer broker gets shares in the eventuality of default by the selling broker. This default occurs when a short seller fails to square up the position, or a seller fails to deliver shares on time, or a seller delivers bad/wrong shares.

The whole process of this auction event can be illustrated as under:

An auction is a mechanism utilised by the exchange to fulfill its obligation towards the buying trading members. Thus, when the selling broker fails to deliver the shares, exchange conducts an open market purchase by way of an open auction and the shares so bought through the auction are delivered to the buying broker.

If the shares could not be bought in the auction i.e. if the shares were not offered for sale in the auction, the exchange squares up the transaction as per guidelines. In the Indian Market, the guideline in force stipulates that the transaction is squared up at the highest price on the NSE from the relevant trading period till the auction day or at 20% above the last available closing price on the NSE on the auction day, whichever is higher. The pay-in and pay-out of funds for auction square-up is held along with the pay-out for the relevant auction.

Roles and Responsibilities of Brokers

Regardless of whether the broker charges high or low commissions, all brokers are regulated by the Securities and Exchange Commission [SEC] in the US and similar agencies in other countries. They are required to meet certain standards when dealing with customers. Specifically, the Securities and Exchange Act of 1934 puts forth certain provisions that all brokers must adhere to. These provisions are provided below:

Duty of Fair Dealing: This includes the duty to execute orders promptly, disclosing material information (information that a broker’s client would consider relevant as an investor), and charge prices that are in line with competitors.

Duty of Best Execution: The broker has a responsibility to complete customer orders at the most favorable market prices possible.

Customer Confirmation Rule: The broker must provide the investor with certain information, at or before the execution of the order (i.e. date, time, price, number of shares, commission, and other information).

Disclosure of Credit Terms: At the time an account is opened, a broker must provide the customer with the credit terms and, in addition, provide credit customers with account statements quarterly.

Restriction of Short Sales: This rule bars an investor from selling an exchange-listed security that they do not own (in other words, sell a stock short) unless the sale is above the price of the last trade.

Trading During Offerings: Rule 101 prohibits the broker from buying a stock that is being offered during the "quiet period"—one to five days before and up to the offering.

Restrictions on Insider Trading: Brokers have to establish written policies and procedures to ensure that employees do not misuse material nonpublic (or inside) information.