Settlement

Settlement is the work of the back office (operations and settlement): before the settlement date it checks payments against the terms of the trades, and after the settlement date it reconciles receipts. It checks the cash flows in each currency together with the dealer responsible for that currency. The credit department that sets settlement risk limits and internal audit, which audits the settlement procedures, are also involved.

What goes wrong when settlement does not happen as planned

If settlement does not happen as planned, a financial institution can lose funds it expected to receive or have to raise replacement funds in a hurry. The possibility of suffering a loss because settlement does not take place as planned is called settlement risk¹. Consider a hypothetical example in which a financial institution pays 10 billion yen to a counterparty and receives US dollars from it on the same day. If the counterparty fails after the yen has been paid, the institution cannot receive the dollars and may lose the full 10 billion yen it paid². Even if the counterparty has not failed, a receipt delayed by an operational error or a system outage leaves the institution short of money it was counting on for other payments, and it has to raise replacement funds in a hurry².

Settlement risk has four aspects¹. The credit aspect is never receiving the amount due. The liquidity aspect is not receiving it at the scheduled time and needing funds to cover the gap. The operational aspect is operational risk from problems in operations and systems. The legal aspect comes from uncertain legal relationships, such as whether netting is legally enforceable. Settlement work exists to prevent these losses: it makes and receives payments on the terms of each trade and confirms quickly that they have been completed.

Settlement is complete when funds have been transferred unconditionally and irrevocably in accordance with the terms of the trade and the obligation has been discharged³. The due date of a payment is called the settlement date, and it is usually the day on which the receiving party can use the funds³. The processing that fixes the amount due on the settlement date (such as the interest amount on an interest rate swap) is covered in Lifecycle Event Processing. Delivering collateral is also a form of settlement.

From checking payments to reconciling receipts

Settlement work runs in order: checks before the settlement date, payment instructions, payments and receipts on the settlement date, and reconciliation of receipts after the settlement date. The number of days from the trade date to the settlement date is written as a count of business days, such as "T+2" (two business days after the trade date)⁴. The following examples of settlement cycles come from spot FX and securities. Around 1999, spot FX trades generally settled two days after the trade date⁵. For Japanese securities, the settlement cycle for over-the-counter trades in Japanese government bonds was shortened from T+2 to T+1 in May 2018, and that for equities and other securities from T+3 to T+2 in July 2019⁶.

Settlement work is mainly handled by the back office, which checks the cash flows in each currency together with dealers in the front office (sales and trading). Following the 1998–1999 examination manual of the US Federal Reserve Board and the code of conduct for foreign exchange market participants (the FX Global Code, December 2024 version), the steps are as follows.

Figure description

The figure shows the flow from checking payments to reconciling receipts, with numbers matching the steps below. The back office checks payments against the terms of the trades, and then the dealer responsible for each currency checks the cash flows on the settlement date together with the back office. The back office sends payment instructions and tells the bank holding the account which receipts are expected. On the settlement date, funds are paid and received through the bank holding the account and the settlement system. Afterward, staff not involved in processing the payments compare the expected cash flows with the actual flows through the account. The arrows follow the order of the step numbers. Steps 1 to 4 come before the payments and receipts on the settlement date (step 5), and the reconciliation of receipts (step 6) comes after them.

1. Check payments against trades (back office). Check each payment against the terms of its trade to confirm that the amount, the date, and the payment instructions are correct (examination manual⁷).
2. Check the cash flows in each currency (back office and the dealer responsible for that currency). Confirm that the cash flows on the settlement date match the net of the trades settling that day (examination manual⁷). Fund each account used for settlement and project its balance so that it does not run short (FX Global Code⁸).
3. Send payment instructions (back office). Send them as early as possible, allowing for time zone differences and the cutoff times of the banks asked to make the payments (FX Global Code⁸).
4. Advise expected receipts (back office). Tell the bank holding the account which amounts are expected, so that a missing receipt is noticed (FX Global Code⁸, examination manual⁷).
5. Pay and receive funds on the settlement date (the bank holding the account and the settlement system). A payment instruction reaches the receiving party through the bank holding the account or a domestic settlement system, where final payment is made (examination manual⁵).
6. Reconcile receipts (staff not involved in processing the payments). Compare the expected cash flows with the actual flows through the account (FX Global Code⁹).

Consider a hypothetical example in which Bank D (fictional) has agreed to settle three payments and receipts with a counterparty on one settlement date on a net basis. In yen, it pays 500 million yen on trade A and receives 300 million yen on trade B. In US dollars, it receives USD 1 million on trade C. The yen amounts are netted by 300 million yen, so the institution pays 500 − 300 = 200 million yen. In step 1, it checks the amount, the date, and the payment instructions of trade A, which is a payment, against the terms of the trade. In step 2, it confirms with the dealer responsible for each currency that the day's cash flows come to a net payment of 200 million yen and a receipt of USD 1 million. In step 6, staff not involved in processing the payments check whether the USD 1 million arrived in the account. If the receipt cannot be confirmed, the institution notifies the counterparty at once, as described in the section "Reconciling receipts and handling payments that do not arrive."

A payment instruction can still be canceled after it has been sent, up to a set time. After that time, the payment cannot be stopped without the consent of a third party⁵. In the examination manual of around 1999, operational, economic, and legal factors meant that at many financial institutions, instructions became effectively irrevocable one or two business days before the settlement date⁵.

Standard settlement instructions fixed in advance

Standard settlement instructions (SSIs) are instructions agreed with a counterparty in advance for each product and currency and used for settling all trades in that product and currency. Each trade settles according to the SSI in effect on the value date¹⁰. Using SSIs is said to greatly reduce the number and size of differences caused by misdirected funds¹¹.

For foreign exchange, the FX Global Code calls for the following in handling SSIs¹⁰. SSIs are used, where practicable, with every counterparty in a trading relationship and for all relevant products and currencies. SSIs are entered, authenticated, and maintained by staff separate from trading and sales (segregation of duties), and ideally separate from the staff responsible for settlement as well. Each SSI has a defined start date, additions and amendments are approved after review by at least two people, and a record is kept. When an SSI changes, the counterparty is notified well before the new SSI takes effect.

Using more than one set of instructions with the same counterparty for the same product and currency can create settlement risk. Multiple instructions are therefore limited to cases with a business reason, such as different business lines using separate SSIs. When they are used, a default SSI applies unless notified otherwise¹⁰. For trades where no SSI can be used, alternative instructions are sent as soon as possible by a secure method such as an authenticated message and verified during the exchange of the trade confirmation¹⁰.

Payment netting

Payment netting offsets the amounts paid and received with the same counterparty on the same day in the same currency, so that only the difference is paid¹³. Consider a hypothetical example in which, on one settlement date, a financial institution has the following three payments with a counterparty.

Without netting, there are three payments, and the institution pays 500 million yen. With netting, there are two: the institution pays 200 million yen and receives USD 1 million. Payments in different currencies are not offset, so there is one payment per currency¹³. Because the amount paid is smaller, the amount that could be lost by paying without receiving is also smaller¹⁴.

On the other hand, netting arrangements cost money to use. In the examination manual of around 1999, netting was most effective with counterparties that had a large two-way flow of trades, and it was sometimes worth the cost only for institutions with heavy trading volume¹³.

Netting requires a legally binding agreement¹³. Payment netting in foreign exchange is supported, where practicable, by market-standard documentation or similar (FX Global Code¹⁴). The individual trades are confirmed before they enter the netting calculation, and the net amounts are confirmed with the counterparty in each currency at a cutoff time agreed in advance¹⁵. In the examination manual of around 1999, there was also an informal practice in which the two back offices agreed by telephone on the day before settlement to pay only the net amount. This practice might not be backed by a legal opinion, so institutions using it needed to understand its legal, credit, and liquidity risks¹³.

Payment netting is a different mechanism from close-out netting, which applies when a counterparty defaults¹³. Payment netting offsets the day's payments in normal times. Close-out netting, when a petition for bankruptcy proceedings or similar is filed against a counterparty, combines the values of all outstanding trades into a single claim or obligation¹⁶.

How the money moves

Yen is paid and received mainly by transfers between current accounts at the Bank of Japan, and foreign currencies mainly through accounts held at banks abroad. In an FX trade, the two currencies move through separate channels, and the time gap between them is a source of loss.

The core of yen settlement is the Bank of Japan Financial Network System (BOJ-NET), operated by the Bank of Japan. The BOJ-NET Funds Transfer System settles funds transactions between financial institutions and the cash legs of securities transactions such as Japanese government bonds by transfers between current accounts at the Bank of Japan¹⁷. Private-sector settlement systems also complete their final funds settlement in the BOJ-NET Funds Transfer System¹⁷. Yen funds arising from FX trades between financial institutions and similar transactions are settled in the Foreign Exchange Yen Clearing System, operated by the Japanese Bankers Association, which uses BOJ-NET to process payment instructions¹⁸. BOJ-NET uses the international standard ISO 20022 for messages on cross-border remittance transactions, such as Foreign Exchange Yen Clearing¹⁹. A financial institution that is not a direct participant in a settlement system asks a direct participant to settle for it²⁰.

Financial institutions ask banks abroad to make and receive foreign currency payments. From the requesting institution's point of view, a bank that takes on foreign currency settlement on its behalf is called a correspondent bank²⁰. The institution's own account at a correspondent bank is called a nostro account, and foreign currency payments, receipts, and reconciliation go through this account⁸⁹. If both parties to a trade hold accounts at the same correspondent bank, the trade can settle by a book transfer at that bank⁵.

In a yen-dollar trade, even with the same settlement date, the dollars settle during New York hours and the yen during Tokyo hours, so the yen is paid first. As in the example at the start of this page, if the counterparty fails in between, the institution may lose the full principal²¹. The time from when a payment instruction can no longer be canceled until the receipt is confirmed can stretch to several days²¹.

One way to remove this timing risk is payment versus payment (PvP), which makes the payments in the two currencies at the same time. FX trades are settled through PvP settlement services wherever possible (FX Global Code¹⁴). One such service is CLS Bank, set up with capital from major private banks and launched in 2002. Around 2009, CLS stood between the parties to a trade and settled the two currencies simultaneously on its accounts only once each party was in a position to deliver the currency it was paying²².

Payments on trades cleared through a central counterparty (CCP) are covered in Cleared vs Bilateral Trades.

Departments involved and their roles

Many departments are involved in settlement, including trading, credit, and operations². The following table lists the functions and roles named in the 1998–1999 examination manual and the FX Global Code. How departments are divided and named differs between financial institutions, and an institution with a small volume of trading in simple products may not need the same level of automated systems and policies as a highly active one².

Reconciling receipts and handling payments that do not arrive

Reconciling receipts means comparing expected cash flows with the actual flows through the account on a regular basis. The sooner the reconciliation, the sooner missing or wrong entries are found and the true account balances are known⁹. Around 1998, reconciliation of accounts abroad always happened after the fact, because it had to wait for the account statements to arrive⁷.

Late reconciliation lengthens the time for which the institution carries settlement risk⁵. The Bank of Japan's 2000 paper says that settlement risk needs to be managed as ending not when funds arrive but when the receipt is confirmed²⁵. For example, if reconciliation cannot be done until the morning after the settlement date, the institution may send that day's irrevocable payments to a counterparty that failed to pay the day before⁵.

A payment due on the settlement date that does not arrive is a settlement fail. Fails arise not only from the counterparty's default but also from operational errors such as payments sent to the wrong place²²⁶. The FX Global Code calls for procedures to detect non-receipt of payments, late receipt, incorrect amounts, duplicate payments, and stray payments, and to notify the relevant parties²⁷. When a payment does not arrive, the institution immediately notifies the counterparty's operations or trading unit and updates its settlement risk exposure with the latest projected cash flows. A party that failed to pay on the scheduled date, or that received a payment in error, arranges for the correct value to be applied or pays compensation. The institution also considers limiting its dealings with a counterparty that keeps failing to settle²⁷.

The 1998 examination manual says that unsettled trades are to be watched closely, unusual problems escalated to the chief dealer and senior back-office staff, and further action left to senior management²³. Around 1999, some institutions deducted fails from the limit set for each counterparty or reviewed a series of fails to see whether the cause was more than a procedural error²⁶.

Notes

1. Bank of Japan, "金融機関の決済リスク管理について" (Settlement risk management at financial institutions, February 2000), "２．決済リスクとは何か" (2. What settlement risk is), page 6 (in Japanese). ↩ ↩²

2. Board of Governors of the Federal Reserve System, "Trading and Capital-Markets Activities Manual," Section 2021.1 "Counterparty Credit Risk and Settlement Risk" (March 1999), page 1. ↩ ↩² ↩³ ↩⁴ ↩⁵ ↩⁶

3. "金融市場インフラのための原則" (Principles for financial market infrastructures, provisional Japanese translation; April 2012), paragraph 3.8.1 (pages 90–91) (in Japanese). The English original is CPSS-IOSCO, "Principles for financial market infrastructures" (April 2012), which uses the same paragraph numbers. ↩ ↩²

4. Board of Governors of the Federal Reserve System, "Trading and Capital-Markets Activities Manual," Section 4210.1 "Canadian Government Bonds" (February 1998), page 1. The manual uses the wording "two market days after the trade date (T+2)." ↩

5. Board of Governors of the Federal Reserve System, "Trading and Capital-Markets Activities Manual," Section 2021.1 (March 1999), page 2, "Measuring FX Settlement Exposures." ↩ ↩² ↩³ ↩⁴ ↩⁵ ↩⁶ ↩⁷ ↩⁸ ↩⁹

6. Bank of Japan, "決済システムレポート 2024" (Payment and Settlement Systems Report 2024, September 2024), page 9 (in Japanese). ↩

7. Board of Governors of the Federal Reserve System, "Trading and Capital-Markets Activities Manual," Section 2060.1 "Operations and Systems Risk (Back-Office Operations)" (February 1998), pages 4–5, "Foreign Payments." ↩ ↩² ↩³ ↩⁴ ↩⁵ ↩⁶

8. Global Foreign Exchange Committee, "グローバル外為行動規範" (FX Global Code, December 2024 version, provisional Japanese translation by the Tokyo Foreign Exchange Market Committee), Principle 53 (pages 50–51) (in Japanese). The English original is Global Foreign Exchange Committee, "FX Global Code" (December 2024), https://www.globalfxc.org/uploads/fx_global.pdf; the principle numbers are the same, and the page numbers are those of the translation. ↩ ↩² ↩³ ↩⁴

9. Global Foreign Exchange Committee, "グローバル外為行動規範" (FX Global Code, December 2024 version, provisional Japanese translation by the Tokyo Foreign Exchange Market Committee), Principle 54 (page 51) (in Japanese). ↩ ↩² ↩³ ↩⁴

10. Global Foreign Exchange Committee, "グローバル外為行動規範" (FX Global Code, December 2024 version, provisional Japanese translation by the Tokyo Foreign Exchange Market Committee), Principle 51 (pages 49–50) (in Japanese). "In effect on the value date" is from the English original, FX Global Code, Principle 51: "settled in accordance with the SSIs in force on the value date" (the provisional Japanese translation says the date of execution). ↩ ↩² ↩³ ↩⁴ ↩⁵ ↩⁶ ↩⁷

11. Board of Governors of the Federal Reserve System, "Trading and Capital-Markets Activities Manual," Section 2060.3 "Operations and Systems Risk (Back-Office Operations): Examination Procedures" (February 1998), pages 3–4, "SETTLEMENT PROCEDURES," item 2. ↩

12. Global Foreign Exchange Committee, "グローバル外為行動規範" (FX Global Code, December 2024 version, provisional Japanese translation by the Tokyo Foreign Exchange Market Committee), Principle 52 (page 50) (in Japanese). ↩ ↩²

13. Board of Governors of the Federal Reserve System, "Trading and Capital-Markets Activities Manual," Section 2021.1 (March 1999), pages 3–4, "Netting." ↩ ↩² ↩³ ↩⁴ ↩⁵ ↩⁶

14. Global Foreign Exchange Committee, "グローバル外為行動規範" (FX Global Code, December 2024 version, provisional Japanese translation by the Tokyo Foreign Exchange Market Committee), Principle 35 (pages 40–41) (in Japanese). ↩ ↩² ↩³

15. Global Foreign Exchange Committee, "グローバル外為行動規範" (FX Global Code, December 2024 version, provisional Japanese translation by the Tokyo Foreign Exchange Market Committee), Principle 50 (pages 48–49) (in Japanese). ↩

16. "金融機関等が行う特定金融取引の一括清算に関する法律" (Act on Close-out Netting of Specified Financial Transactions Conducted by Financial Institutions, etc., in Japanese), Article 2, paragraph 4 (close-out netting events) and paragraph 6 (close-out netting). ↩

17. Bank of Japan, "決済システムレポート 2024" (Payment and Settlement Systems Report 2024, September 2024), page 9, "１．日銀ネット（当預系・国債系）" (1. BOJ-NET (Funds Transfer System and JGB system)) (in Japanese). ↩ ↩²

18. Bank of Japan, "決済システムレポート 2024" (Payment and Settlement Systems Report 2024, September 2024), page 8, Chart 2 "わが国における主要な民間 FMI" (Major private-sector FMIs in Japan) (in Japanese). ↩

19. Bank of Japan, "決済システムレポート 2024" (Payment and Settlement Systems Report 2024, September 2024), page 11 (in Japanese). ↩

20. Bank of Japan, "金融機関の決済リスク管理について" (Settlement risk management at financial institutions, February 2000), page 9 and Chart 1 "決済システムにおける参加者の位置付け" (Positions of participants in settlement systems) (in Japanese). ↩ ↩²

21. Bank of Japan, "金融機関の決済リスク管理について" (Settlement risk management at financial institutions, February 2000), BOX 2 "外為決済リスクについて" (On FX settlement risk), page 25 (in Japanese). ↩ ↩² ↩³

22. Bank of Japan, "頑健な決済システムの構築に向けて" (Toward robust payment and settlement systems; speech by Governor 白川方明, November 13, 2009), the paragraph describing "外国為替決済における「取りはぐれ」防止の仕組み" (the mechanism for preventing failure to receive in FX settlement) (in Japanese). ↩

23. Board of Governors of the Federal Reserve System, "Trading and Capital-Markets Activities Manual," Section 2060.1 (February 1998), page 4, "Settlement Process." ↩ ↩² ↩³

24. Board of Governors of the Federal Reserve System, "Trading and Capital-Markets Activities Manual," Section 2021.1 (March 1999), pages 4–5, "Internal Audit." ↩

25. Bank of Japan, "金融機関の決済リスク管理について" (Settlement risk management at financial institutions, February 2000), "ロ．決済リスクの測定・モニタリング" (b. Measuring and monitoring settlement risk), page 10 (in Japanese). ↩

26. Board of Governors of the Federal Reserve System, "Trading and Capital-Markets Activities Manual," Section 2021.1 (March 1999), page 3, "Procedures." ↩ ↩²

27. Global Foreign Exchange Committee, "グローバル外為行動規範" (FX Global Code, December 2024 version, provisional Japanese translation by the Tokyo Foreign Exchange Market Committee), Principle 55 (page 52) (in Japanese). ↩ ↩²

28. Board of Governors of the Federal Reserve System, "Trading and Capital-Markets Activities Manual," Section 2021.1 (March 1999), page 3, "Limits." ↩