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Settlement involves the delivery of securities or cash from one party to another following a trade. Payments are final and irrevocable once the settlement process is complete.
Physically settled derivatives, such as some equity derivatives, require securities to be delivered to central securities depositories.
In foreign exchange trades, settlement is typically facilitated by CLS Bank or via correspondent banks that allow counterparties to exchange currencies. Since transfers occur independently through correspondent banking, counterparties are subject to principal and liquidity risk to the full value of the trade.
Settlement of cash-settled interest rate swaps is in the form of periodic interest payments based on an interest rate over a term to maturity.
Settlement risk – the risk that one counterparty will fail in its obligations to the other – can be mitigated by the post-transaction process of clearing, as well as by real-time gross settlement (RTGS) systems. These transfer money or securities from one bank to another in real time rather than at the end of the day but do not provide the benefit of netting transactions.
T+1 and T+2 are abbreviations that refer to the timing of settlement, expressed in days after the transaction date (T). This is known as post-trade settlement.
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