Although not many of us think about how cash moves from one bank account to another, it is important to know how Eurobonds move between accounts.
Where cash is held in a bank account, Eurobonds are held in a so-called “custody account”. Eurobonds are said to “settle” in a custody account whenever a purchase or sale is made. A vast financial market infrastructure is in place to connect custody accounts worldwide in order for bonds to settle correctly. This infrastructure is built and maintained by International Central Securities Depositories, or “ICSDs”. Such depositories are usually banks that have a single purpose: provide settlement and custody services.
ICSDs function as warehouses for Eurobonds and for a fee, investors can store their Eurobonds with them. A custody account can be opened directly with an ICSD, however due to numerous thresholds the majority of (retail) investors have a custody account with bank who on their turn have a direct relationship with the ICSD.
When a Eurobond is purchased, it is conventional that the buyer and seller agree to exchange the security two business days after the trade date. This is a so-called “T+2” settlement convention.
It is theoretically possible to agree on any settlement date, however it is rare to settle bonds >5 business days after the trade date (“T+5”). The main reason for securities not settling on the trade date is to allow for the buyer and seller to make the necessary logistical, funding and system arrangements to ensure smooth settlement.
Eurobonds can be listed on an exchange when issued. There are several reasons why an issuer may decide to list its Eurobond on an exchange.
A listing usually leads to more brand awareness for the issuer. Also, the rigorous requirements that an exchange imposes on an issuer strengthens the governance standards or an issuer. This, subsequently, is beneficial to the investor in that Eurobond and helps the issuer build and or maintain its reputation.
Finally, a listing may help ensure an active secondary market in the Eurobond. Institutional investors may have a listing requirement included in their mandates. In other words, such investors cannot purchase any Eurobonds that are not listed.
(International) Central Securities Depositories (“ICSDs”) provide a centralised function in order to ensure the movement of Eurobonds from the account of a seller to the account of a buyer. Depositories provide the market infrastructure needed for these transfers and are the focal point for the settlement departments of market participants. CSD responsibilities are usually taken on by banks who have a single purpose: settlement & custody services. Standalone software or cloud-based modules are offered by depositories to provide market participants with an easy method to instruct on Eurobond purchases and sales. A matching function is provided where bonds will only exchange once both the buyer and seller have instructed and therefore confirm the underlying transaction. In this way, Eurobonds can never exchange hands (settle) if instructions do not match. This is one of the key operational risk mitigants of the bond market.
The seller of a Eurobond delivers the security on the settlement date and receives the agreed cash amount in return. This is called a “Delivery vs Payment (DVP)” instruction and the security will only be delivered once the cash has been received.
For the buyer, the opposite happens and is referred to as a “Receive vs Payment (RVP)” instruction.
Most Eurobond transactions settle with a DVP/RVP instruction, however “Free of Payment (FOP)” instructions are fairly common. Usually internal Eurobond transfers between portfolios within the same fund or in-house retail flows settle Free of Payment.
Although most bonds settle on their agreed settlement date, late settlements do happen. We will address operational, commercial, regulatory and reputation risks.
Late settlements tend to occur more often in times of market stress, around new issuance or when transacting with new counterparties.
Often a late settlement is the result of a chain reaction or knock-on effect, where one seller is defaulting on delivering the security on the settlement date and subsequent buyers will face a delay in receiving the security. Below is an example with three different investors, where a bond settles 4 days later than agreed and causes a knock-on effect to another investor.
Reasons for late delivery can include human error by back/front office, delays in repo markets, system issues or the unwillingness to cover a short position.
In order mitigate late settlement in a security, Investor B can use a different position other than the purchased position from Investor A. This would assume that Investor B has another position. Alternatively, Investor B can borrow the Bond from another investor. This would assume Investor B is able to borrow through so-called “repurchase transactions”.
No commercial loss or gain is realised with a late settlement; however it usually results in reputational damage.
Investors holding different currencies usually require multiple cash accounts. For example, a USD account for US Dollars or a EUR account for Euro.
For Eurobonds, however, a single custody account will safekeep any Eurobond purchased. A Nigerian Eurobond denominated in US Dollars, a South African Eurobond in Japanese Yen or a Senegalese Eurobond in Euro can all be held in the same custody account.