Although the purchase or sale of an option settles T + 1, when an options holder exercises the contract, the underlying stock that changes hand settles T + 2. If a call buyer exercises the call, his payment is due, and the securities must be delivered by the seller, within the usual T + 2 settlement cycle. When a put is exercised, the holder delivers the stock to the writer, and the writer delivers payment to the put buyer within the usual T + 2 cycle.
U.S. Treasuries trading among investors settle T + 1. But, when they are auctioned by the Federal Reserve Board, those transactions settle T + 2. T-Bills are auctioned each Monday. Notes and Bonds have rarer, scheduled auctions.
As we saw, mutual fund trades for the shareholders of the fund execute once per day, only after the markets close. If an investor misses the trading deadline for that day, the trade is not executed until the close of the next trading day.
Most open-end mutual funds settle customer transactions on the next business day. Occasionally, a fund has provisions in its shareholder agreement allowing it more time to settle transactions. However long the settlement period is, fund buyers must have cash available by settlement, and fund sellers are unable to use cash proceeds for other purposes until the trade settles.
Money-market mutual fund transactions settle same-day. That is why customers often use money market mutual funds as sweep options, giving them fast access to funds without having to wait an extra day to clear transactions.
Other types of funds governed by similar rules to open-end funds have different settlement rules. For example, ETFs are like mutual funds, but follow the same rules as stocks. Therefore, they settle regular-way T + 2. Closed-end funds also trade like any other share of common stock, with a regular-way settlement period of T + 2.
Close-Outs
On some transactions, either the buy or sell side does not come through with their part of the obligation. Either the seller fails to deliver the securities sold in the trade or the buyer fails to transmit the funds to pay for the trade.
Buy-Ins
Failure to deliver securities does not force a cancellation of the trade. Rather, after proper procedures have been followed, the broker-dealer whose customer purchased the securities completes a buy-in to obtain the securities for the customer.
If both firms are members of a registered clearing agency, notice is sent through the NSCC, FICC, etc. If not, notice can be sent by fax, computer system, or any system providing return receipt capability. The firm transmitting the buy-in is required to maintain the return receipt with the buy-in notice on its books and records.
The buying broker-dealer may close out the position no sooner than the third business day following the settlement date. The firm must provide written notice to the other side by noon two business days before executing the buy-in. The notice informs the sell-side of the buyer's intention to purchase securities not delivered by the seller for the account and expense of the seller. If the market price of the securities not delivered hasn't moved, the sell-side will pay back the funds already delivered by the buy-side. If the market price has risen, the sell-side will realize a loss.
After executing the buy-in, the broker-dealer must notify the party for whose account the securities were bought as to the quantity purchased and the price paid. This notice is due by 6 PM on the date the buy-in is executed and must, again, be sent through a system providing return receipt capabilities.
When the sell-side receives the initial buy-in notice, the member can claim "no fault." This means the failure to deliver is due to a third party typically, another member not delivering to them. The seller in this case re-transmits the written notice to the third party. This extends the proposed buy-in date by up to seven calendar days.
Also, the firm may effect partial delivery by the proposed due date to extend the process.
Sell-Outs
Buy-Ins follow a complicated procedure in which the sell-side can get an extension, or can complete a partial delivery before the proposed buy-in date to buy some time.
With a sell-out, on the other hand, things are simple. If a member fails to pay for securities sold by another member by settlement, the sell-side can execute a sell-out any time after settlement. Unlike with the buy-in, no written notice is required before effecting a sell-out.
As with a buy-in, if the sale price is lower, the loss is borne by the other side the contra party to the trade.
Aged Securities Fails
If a customer has a fail to deliver after selling stock, the firm must set up a fail to deliver account on its books in the amount of the sales proceeds for the transaction. Surprisingly, at this point the position is still an allowable asset. However, the longer the fail-to-deliver drags on, the bigger the required haircut.
On the fifth business day following settlement the fail-to-deliver must be aged for purposes of computing net capital. The position would now be marked to the market with a 15% haircut taken on that. Even though the asset has been aged, it is still an allowable asset. It just needs to get itself an extra-short haircut to be counted in the firm's net capital.
Standing Settlement Instructions (SSI)
Regular way is the typical method used to settle securities transactions, but for many institutional accounts, DVP/RVP is the default method.
Customers, especially institutional investors, complete documents called standing settlement instructions to be used for all transactions.
As we see from this explanation at a large financial firm's website, "These Standard Settlement Instructions are to be used for all transactions with HSBC Bank PLC ("HSBC"), in the products denoted, unless otherwise specified at transaction level.
As it states, the customer can specify a different method on any transaction. But, otherwise, the standing settlement instructions are used by default. At the same HSBC website we see that settlement instructions vary based on where the investor is located and the type of security or commodity being traded. Among many, there is a form for "USA: Options," one for "USA: Fixed Income Mortgage-Backed Securities," and one for "USA: Precious Metals."
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