The SEC and Colombo Stock Exchange (CSE) announced that they are rolling out the new settlement method known as Delivery Vs Payment (DVP) Method on 21st July subject to the final round testing and mock runs.
This announcement made a buzz in the market and some say it’s a good move to escalate CSE towards frontier market status from emerging market, while others fear it will affect the retailers and may create a bloodbath in the market. In an attempt to educate our readers on the DVP method, this article tries to give a simple and comprehensive idea of the DVP method, its advantages and disadvantages.
What is Delivery versus payment Method (DVP)
DVP (delivery versus payment) is a settlement technique used in the securities market. It basically ensures that securities are only transferred when payment has been paid. It requires the buyer to complete their payment obligations prior to or at the time of delivery of the acquired security(s).
As per Investopedia.com, Delivery versus payment (DVP) is a securities industry settlement method that guarantees the transfer of securities only happens after payment has been made. DVP stipulates that the buyer’s cash payment for securities must be made prior to or at the same time as the delivery of the security.
Delivery versus payment (DVP) is a settlement method that requires that securities are delivered to a particular recipient only after payment is made.
Further breaking it down
- Delivery versus payment is a securities settlement process that requires that payment is made either before or at the same time as the delivery of the securities.
- The process is meant to reduce the risk that securities could be delivered without payment or that payments could be made without the delivery of securities.
- The delivery versus payment system became a widespread industry practice in the aftermath of the October 1987 market crash.
- It’s also known as Cash on delivery or Delivery against cash
Non-DvP settlement processes typically expose the parties to settlement risk. FOP settlement involves delivery of the securities without a simultaneous transfer of funds – hence ‘free of payment’. Funds may either be remitted by other, mutually agreed means, or payment may not be made at all.
The objective of the delivery versus payment (DVP) technique is to minimize a number of risks. The following are the many types of risks that a trading party may face when engaging in a securities market transaction.
Credit risk is the possible inability of the buyer to settle their obligation in full value, either when due or any time thereafter.
Replacement cost risk
Replacement cost risk is the risk of loss of unrealized gains. Unrealized gain is determined by comparing the security’s market price at the time of default with the contract price.
The seller is exposed to replacement cost loss if the market price is below the contract price, whereas the buyer is exposed to a replacement cost loss if the market price is above the contract price
Principal risk is the risk of loss of the full value of securities or funds that the non-defaulting counterparty’s transferred to the defaulting counterparty. The buyer is at risk if it is possible to complete payment but not receive delivery, and the seller is at risk if it is possible to complete delivery but not receive payment.
Liquidity risk refers to the risk that the party involved will not settle an obligation for the full value when due but will do on some unspecified date thereafter.
Systemic risk can be broadly explained as the possible inability of one institution involved to meet its obligations when due will cause other institutions to fail to meet their obligations when due.
Eliminating the Risks
The DVP method essentially sees the elimination of the risks above as follows:
The delivery versus payment system easily avoids principal risk because it is essentially structured to avoid such events. When following the DVP method, the delivery of securities is only, and only, once payment is made. It eliminates principal risk.
Since DVP eliminates principal risk, the probability of not meeting delivery and/or payment obligations also decreases, reducing the possibility of liquidity risk.
Overall, the implementation of DVP method is greater good for the CSE growth and it will pave the way to move towards frontier market status from the emerging market status
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