Delivery versus Payment Contract:
Delivery versus Payment contracts deals with the settlement of securities. The concept sets forth that the delivery of financial securities is exchanged only when the buyers make full payment for the transactions. This process nearly eliminates the settlement risk of a counterparty defaulting on honoring obligation in case of distressed financial markets.
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How DVP Contracts have come into existence? Explain its working methodology:
In October 1987, the headline index of Unites States shed value of more than 20% on unpleasant news of the US entering bear markets and prospective flow of news made investors nervous enough to place very large sell orders with a very low-risk appetite for buyers. The popular hedging strategy aggravated the selling pressures by heavier shorting of the index to hedge the portfolios. Ultimately, leveraged economies faced settlement risk of paying liabilities and delivering securities. Such settlement risk could give rise to systematic risk and credit risk. To overcome such potential risks, a section of countries came forward and founded the concept of DVP contracts to nearly eliminate settlement risks.
DVP contracts ensure the smooth functioning of clearing and settlements. On one side, payments are made instantly, and the simultaneous delivery of financial instruments takes place. Such a process leads to dismissal of settlement risk which can cause potential financial crises around the globe. DVP contracts can be settled on a gross basis (requiring larger liquidity) or a net basis (end of the day). The process of DVP contracts is materialized through SWIFT messages.
- Bank A has 8 units of securities to be transferred, while bank B has 6 units of cash to be paid to bank A.
- Bank A, the seller of securities creates the security transaction & Bank B, holder of cash creates cash instruction as shown in step 1. As shown in the step-1 diagram, no party has signed any instructions.
- Going to step-2, Bank A sends its security instruction to Bank B without putting its signature. Bank B verifies paying 6 units of cash and receiving 8 units of securities from Bank A. Bank B verifies security instructions, combines its cash instructions, and signs its part of transaction & sends it to Bank A.
- Going to step-3, Bank A verifies all instructions and signs its part of the transaction and sends it to payment mechanism for final clearance & settlement.
- Proceeding to step-4, the Payment mechanism ensures receipt of cash & delivery of securities simultaneously.
Thus, the DVP mechanism works in a way that one leg of settlement is linked to another leg of settlement & ensures the settlement of both legs. DVP mechanism was proposed to ensure the risk of the seller not being able to deliver securities despite receiving cash or buyer not being able to pay cash despite receiving securities.
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Advantages of DVP Contracts:
- DVP Contracts nearly eliminate major settlement risks regarding principal capital which can help global financial systems reduce the systemic risk substantially and function efficiently.
- DVP Contracts don’t impair liquidity efficiency.
- DVP Contracts accelerate the speed of settlement transactions.
Disadvantages of DVP Contracts:
- DVP Contracts don’t eliminate replacement cost risk (risk of unrealized gain/loss) & liquidity risks completely.
- DVP Contracts also rely on the efficient functioning of custodians, sub-optimal risk management practices in any section of the financial system can expose institutions to systematic risks.
Author: Ashutosh Buch
About the Author:
Ashutosh Buch is CFP (FPSB India) & has passed Level-I of CFA Program. His primary interest lies in analyzing investments in primary & secondary markets. At present, he focuses on learning the nuances of financial markets & management consulting. He remains committed to his goal of helping businesses scale up & making them ESG-friendly.