What does free of payment mean?

Free of Payment (FOP) Settlement: A Guide

In the world of finance, there are various methods for settling transactions involving the exchange of securities and funds. One such method is Free of Payment (FOP) settlement.

What is Free of Payment (FOP) Settlement?

FOP settlement is a settlement method in which the delivery of securities and the payment of funds are separate and independent processes. In other words, the buyer of the securities is obligated to deliver the funds to the seller without receiving the securities, and the seller of the securities is obligated to deliver the securities to the buyer without receiving the funds.

Risks of FOP Settlement

While FOP settlement may seem straightforward, it poses certain risks, particularly to the party that initiates delivery.

• Delivery Risk: If the seller of the securities delivers the securities but the buyer fails to pay, the seller has recourse only against the buyer. The settlement system does not guarantee payment.
• Payment Risk: If the buyer of the securities pays the funds but the seller fails to deliver the securities, the buyer has recourse only against the seller. The settlement system does not guarantee delivery.

When is FOP Settlement Used?

Despite these risks, FOP settlement is sometimes used in certain situations:

• Credit Risk: If one party has concerns about the creditworthiness of the other party, they may prefer to use FOP settlement to mitigate the risk of receiving funds or securities from an insolvent counterparty.
• Time Constraints: FOP settlement can facilitate faster delivery of securities or funds than other settlement methods, which can be beneficial in time-sensitive transactions.
• Regulatory Requirements: In some jurisdictions, certain types of transactions may require FOP settlement to comply with regulatory obligations.

Alternatives to FOP Settlement

To mitigate the risks associated with FOP settlement, there are alternative settlement methods available:

• Delivery versus Payment (DVP): In DVP settlement, the delivery of securities and the payment of funds occur simultaneously, ensuring that neither party takes on unilateral risk.
• Centralized Clearing Mechanism: A clearinghouse acts as an intermediary between buyers and sellers, facilitating the exchange of securities and funds while managing the settlement risks.

Conclusion

Free of Payment (FOP) settlement is a settlement method that carries certain risks, particularly to the party that initiates delivery. While it may be used in certain situations, such as when there are credit concerns or time constraints, it is important to be aware of the risks and consider alternative settlement methods that mitigate these risks.