What is Delivery Versus Payment?

Investing in stocks can help you build wealth and be more prepared for retirement. While brokerage firms have made it straightforward to buy stocks, a few things happen behind the scenes of every stock transaction. One of those behind-the-scenes events is Delivery Versus Payment (DVP). Discover how DVP works and why it is an important part of every stock trade.

Understanding Delivery Versus Payment (DVP)

Delivery Versus Payment (DVP) is a settlement method for securities like stocks and bonds. Through DVP, a buyer only receives securities after paying for them. While this sounds basic, not every financial firm followed this rule in the 1980s. The crash in 1987 was partially fueled by firms delivering securities before receiving payments or receiving payments without delivering securities.

How Does Delivery Versus Payment Work?

DVP ensures that cash exchanges hands before securities exchange hands. This arrangement ensures cash or securities do not get withheld if the financial markets experience sharp fluctuations. Through DVP, both parties commit to the trade and exchange resources instead of incomplete deals that can take much longer to settle, if they get settled at all.

How Delivery Versus Payment Helps Limit Risk Exposure

DVP reduces risk in the markets and addresses several key components.

Credit Risk

Credit risk represents the likelihood of incurring a loss from a borrower being unable to pay off a loan or another financial obligation. Rising interest rates lead to higher credit risk for lenders who give out variable-rate loans. As debt becomes more expensive, it can lead to a higher credit risk.

If the payment does not arrive before the securities exchange hands or the securities get delivered before the payment, credit risk increases. One side can have a difficult time fulfilling the obligation in a few months or years if the financial markets move sharply in an unfavorable direction. DVP removes credit risk worries since cash and securities immediately swap hands without delay. 

Liquidity Risk

Liquidity risk reflects uncertainty about an individual or company’s ability to cover debt obligations with current cash on hand. A business paying $10,000 per month for a business loan that generates $7,000 in monthly revenue has a higher liquidity risk, especially if the company doesn’t have many assets or cash on hand.

Any delays between the delivery of cash and securities can lead to gaps for a financial firm. Securities can gain value before another party delivers them to the buyer. DVP minimizes liquidity risk by ensuring cash and securities swap hands. One party does not owe the other since the transfer takes place right away.

Principal Risk

Principal risk is a category that reflects various scenarios and events that can hurt a company’s business model or growth prospects. An example of principal risk is if a company experiences significant revenue and earnings decline due to deteriorating demand for a top-performing product or service.

Credit risk and liquidity risk can each increase a firm’s principal risk. Struggles with providing cash or securities can also hurt a company’s reputation, leading to a higher principal risk. DVP adds more trust in the system by ensuring cash and securities get transferred and settled simultaneously instead of a delay on one party’s side.

Systemic Risk

Systemic risk refers to widespread events that can hurt entire industries or broad market segments rather than individual companies. Worsening macroeconomic conditions don’t only affect one company. This scenario creates systemic risk that can impact any company. Worsening macroeconomic conditions typically lead to reduced consumer spending, which can affect a company’s revenue and earnings growth rates.

DVP reduces systemic risk in the stock market because it gives people fewer reasons to panic. If parties cannot deliver on securities, other borrowers may panic and opt to sell their securities to avoid the same fate. This scenario is similar to how Silicon Valley Bank went bankrupt. Clients didn’t want to get left on the hook, so they withdrew their funds from the bank to feel more safe. Declining stock prices can fuel more panic and increase systemic risk, but DVP minimizes this risk in the stock market.

Replacement Cost Risk

Replacement Cost Risk reflects the uncertainty of receiving a suitable replacement if necessary. If a business cannot provide you with the service you wanted, that business may propose a suitable replacement. Sometimes, the replacement is better or identical to the original product or service. However, the replacement may be worse or nonexistent in other cases.

If a broker falls apart before it can settle securities with buyers, the buyers miss out on the opportunity of owning the security. The buyer may also not get their cash back from the defunct broker. DVP eliminates this risk by ensuring cash and securities exchange hands at the same time instead of the possibility of one party delaying their part of the deal.

Delivery Versus Payment Enables Better Financial Markets

DVP has improved how securities get settled and minimizes several market risks. With this model in place, buyers and sellers can feel more confident trading cash and securities. Financial markets have evolved considerably over the years to give buyers and sellers a better experience. DVP represents one of the enhancements financial markets have experienced over the years. 

Frequently Asked Questions