I wonder why not many people are currently asking themselves a very simple question: “Who lost money in #Japan’s stock market crash between Friday and Monday?”
One very peculiar thing about the 1987 crash is that many brokerages went bust. So how is it possible that Japan suffered a stock market crash of a magnitude never experienced before, not even in 1987, and no damage has been reported so far among its major market participants? The answer is, that they haven’t finished “counting the beans” yet.
What the hell am I talking about? I am talking about a very important but often overlooked element of financial system plumbing: the Settlement Process.
What is the definition of the Settlement Process?
“When shares of stock, or other securities, are bought or sold, both buyer and seller must fulfill their obligations to complete the transaction. During the settlement period, the buyer must pay for the shares, and the seller must deliver the shares. On the last day of the settlement period, the buyer becomes the holder of record of the security.”
Pay attention to one important element of the paragraph above: the settlement period.
Exactly what is being described in the paragraph above doesn’t happen right away but takes time. Now the question is, how much time does it take for Japanese securities? 2 days starting from the trade date. Bear this in mind since it is incredibly important.
At this point, let me quickly summarize the settlement process for Japanese securities for you.
1 – Between 48 hours and 24 hours prior to settlement, Custodian Banks have to receive the trade instructions from their clients and promptly “match” these in the JDCC (JASDEC DVP Clearing Corporation) clearing system with the Custodian Banks of their trading counterparts.
2 – Custodian Banks are expected to start the cash provisioning 24 hours prior to settlement at 2 pm JST.
3 – On the settlement date, the buyer is expected to fund his account with the custodian who will then deliver these to his counterpart custodian banks while receiving the securities purchased that will be delivered to the buyer’s account. This process is expected to be completed by 3:30 pm JST.
So what happens if after 2 days either one of the parties isn’t in a position to deliver the cash or the securities agreed? A “Settlement Failure” process is initiated. Precisely:
- If the buyer doesn’t have the cash to finalize the transaction, he will be charged a cash penalty equivalent to ~15% interest rate per annum for each day of delay. This will increase to ~22% after the fifth day of delay.
- If the seller doesn’t deliver the securities within 24 hours after the original settlement date, the JDCC will execute a “buy-in” process that simply stands for going to the market to source the securities and deliver them to the buyer. All costs and price differences incurred will be charged as penalties to the seller.
There is one last element missing from the whole picture, what happens if even after accommodating a settlement postponement a counterpart isn’t still in the condition to fulfill its obligations with the JDCC? In that case, there is a default.
To conclude, the Japanese market crash started last Friday (although like in 1987 stocks were already in a correction process well before that), which means all trades for that day were due to be settled by 2 pm JST on the 6th of August. After knowing this piece of information, do you think it was just a coincidence that #BOJ and MOF gathered for an emergency meeting exactly at 2 pm JST on the 6th of August despite everyone thinking “everything was fine” in the market since the Nikkei was rebounding ~12%? Yes, there is a high chance the authorities gathered to discuss potential settlement problems. However, the bigger market drop was on Monday and all those transactions are due to be settled in the following hours today, 7th August by 2 pm JST. This is why I started the article by saying that if a credit event triggered on Monday, we will know the answer in the following hours, and if what happened was truly worse than 1987, then no one should be shocked to see brokerages and potential banks default on their obligations and close shop.