Risky Business: The Clearance and Settlement of Financial Transactions

Ananth Madhavan, Morris Mendelson and Junius Peake

Rodney L. White Center for Financial Research Working Papers from Wharton School Rodney L. White Center for Financial Research

Abstract: The process of clearing and settling trades involves risks to both investors and the brokerage firms that represent them. Because of the International Organization of Securities Commissions (IOSCO) has appointed a technical committee to explore the problems of clearing and settlement in a global market. We argue for minimizing the length of the settlement cycle. This is a consideration that IOSCO should address.

In this paper we explore the nature of these risks, how they can b reduced; and we develop a way to estimate the size of these risks and their impact on transactions costs. We demonstrate that the risk brokerage firms face increases as the length of the settlement cycle increases. We provide a method to quantify some of the effects on transaction costs of changes in the settlement period. We discuss some strategies that brokerage firms may take to minimize the risk associated with clearance and settlement. And, as noted, we argue for minimizing the length of the settlement cycle.

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