Settlement Period, Settlement Risk
Settlement period is the duration between a transaction date and a settlement date, during which all obligations for the transaction are fulfilled by the involved parties. This period is characterized by the buyer making the required payment to the seller, who in turn delivers the purchased security.
Length of Settlement period
The settlement period is cited as T+1, T+2 or T+3, where T stands for the transaction date. The length of this period varies with the type of transactions. For instance, the settlement period for stocks in the U.S. exchange is three days after the trade (T + 3). On the other hand, mutual funds have a settlement period of one day (T+1) and Forex transactions in the U.S. Treasury are settled two days after the trade (T+2). Foreign shares may have a settlement period that spans months.
However, the settlement period for certain securities can be extended or stretched. This is referred to as extended settlement. For example, the standard T + 3 settlement period for shares may be stretched to a week or more. There are several companies that provide such services online (T + 10, T + 20) or through telephone (T + 25). As of now, the extended settlement facility is available only on UK share trades.
Popularity of Longer Settlement Periods
The popularity of longer settlement periods is found mostly in the real estate industry. The industry typically has a settlement period of 4-6 weeks. This period, however, can be extended or reduced, as per the requirements of the involved parties. Settlement period in the real estate is fixed only after considering aspects such as the arrangement of finance and other practicalities of moving.
Today, certain countries are also reverting to longer settlement periods. For instance, the Zimbabwe Stock Exchange has reverted to its 7-day settlement period since it started to trade in U.S. dollars.
Settlement risk refers to the risk of default by any of the parties involved in a transaction, when the other parties have already made their payments or delivered securities as per the trade agreement.
A type of settlement risk is the foreign exchange settlement risk or cross-currency settlement risk. Famous examples include the closing of Barings (1995) and Bank of Credit and Commerce International (1991), which resulted in considerable losses for the counterparties.