Free of payment fop

What Is Free of Payment (FoP)?

Free of payment (FoP) refers to a securities settlement method where assets are transferred from one account to another without a simultaneous exchange of funds. This distinct process operates within the broader context of securities settlement in financial markets. Unlike standard transactions where cash and securities are exchanged concurrently, an FoP transfer involves only the movement of the security itself. It is a fundamental mechanism within capital markets and is a common procedure facilitated by post-trade infrastructure providers.

History and Origin

The evolution of securities settlement systems has been driven by the need for efficiency and security in transferring ownership of financial instruments. Historically, securities transfers involved physical certificates and manual reconciliation, leading to significant delays and risks. The advent of central securities depositories (CSDs) revolutionized this process by dematerializing and immobilizing securities, allowing for book-entry transfers. Early settlement systems primarily focused on the "delivery versus payment" (DvP) principle, ensuring that the transfer of securities only occurred upon the receipt of corresponding funds, thereby mitigating risk. However, as financial transactions became more complex, specific scenarios emerged where the exchange of securities was necessary without an immediate, linked cash payment. The Banque de France notes that securities settlement systems (SSSs) can provide for the delivery of securities without payment, defining these as free of payment (FoP) transactions. These transactions are used in contexts such as securities lending or collateral mobilization.⁵ The formal recognition and standardization of free of payment processes by CSDs and other market infrastructures became crucial to accommodate these specialized needs, allowing for greater flexibility in certain financial operations while still maintaining overall market integrity.

Key Takeaways

• Free of payment (FoP) is a method of transferring securities without a linked cash payment.
• It is distinct from delivery versus payment (DvP), where securities and funds are exchanged simultaneously.
• FoP transactions are commonly used for internal transfers, collateral movements, or gifts.
• These transfers carry a higher level of delivery risk compared to DvP, as there is no immediate monetary counter-value.
• Proper record-keeping and clear instructions are critical for FoP transactions.

Interpreting the Free of Payment (FoP)

Interpreting an FoP transaction means understanding that the transfer is not a typical buy or sell trade. Instead, it signifies a change in legal or beneficial ownership of a security without the sale or purchase price being settled through the same transfer mechanism. This implies that any associated monetary consideration, if it exists, is settled outside the conventional securities settlement system, or there is no monetary consideration at all. For example, if a security is moved as collateral for a loan, the value of the collateral is relevant, but no cash is exchanged for the security itself in that specific transfer. Similarly, an investor receiving shares as part of a corporate action (like a stock dividend) will see an FoP transfer into their account. The nature of the FoP transaction must be understood within the broader context of the underlying financial activity it supports, such as a securities lending agreement or a gift.

Hypothetical Example

Consider an individual, Sarah, who wishes to transfer 100 shares of XYZ Corp. stock to her sister, Emily, as a gift. Both Sarah and Emily have brokerage accounts.

1. Initiation: Sarah instructs her broker-dealer to transfer 100 shares of XYZ Corp. from her account to Emily's account. Sarah specifies this as a "free of payment" transfer because no money is changing hands for the shares through the brokerage.
2. Processing: Sarah's broker-dealer initiates the FoP transfer through the relevant clearing and settlement systems, such as the Depository Trust Company (DTC). The instruction indicates that only the securities are to be moved, without any accompanying cash leg.
3. Completion: The 100 shares of XYZ Corp. are debited from Sarah's account and credited to Emily's account. No cash is debited or credited from either Sarah's or Emily's linked bank accounts as part of this specific securities transfer. The transfer is complete on the settlement date, typically T+1 or T+2, depending on the asset and jurisdiction, from the trade date of the internal transfer instruction.

This example highlights a direct FoP transfer, where the underlying reason is a gift, and no funds are associated with the security movement.

Practical Applications

Free of payment transfers have several practical applications across the financial industry, facilitating various types of non-sale related movements of securities:

• Internal Account Transfers: Moving securities between different accounts owned by the same individual or entity (e.g., from a taxable account to a trust account).
• Estate Planning and Gifts: Transferring assets to beneficiaries or as gifts, where no monetary consideration is exchanged.
• Collateral Management: Pledging securities as collateral for loans or derivatives transactions. Financial institutions frequently move securities to and from collateral accounts to manage exposures without a simultaneous payment for the securities themselves. The Depository Trust & Clearing Corporation (DTCC) facilitates such movements, stating that participants can pledge securities as collateral for loans or other purposes, and these pledges or releases can be made "free," meaning the money component is settled outside the depository.⁴
• Corporate Actions: Distributing shares as part of stock dividends, stock splits, or mergers, where new shares are issued or exchanged without direct payment from the recipient.
• Securities Lending and Borrowing: The return of borrowed securities to the lender typically occurs as an FoP transfer.
• Correction of Errors: Rectifying erroneous securities transfers by moving them back to the correct account without a cash exchange.
• Regulatory Compliance: Certain regulatory requirements may necessitate the movement of securities between segregated accounts, which are often executed as FoP transfers.

Limitations and Criticisms

While free of payment transfers are essential for certain operations, they are not without limitations and risks. The primary drawback of an FoP transaction is the heightened counterparty risk it entails compared to its Delivery Versus Payment (DvP) counterpart. In an FoP transfer, there is no simultaneous exchange of cash to ensure that both legs of a transaction complete. This means one party relies on the other to fulfill their obligation (e.g., make a payment or return securities) separately. As "The Jolly Contrarian" notes, FoP transactions inherently incur a higher level of delivery risk than the generally used DvP transactions because the delivery of funds and securities do not happen simultaneously.³ If the expected payment or return of securities does not occur, the party that delivered the securities free of payment could face a loss.

Another limitation is the potential for misuse in illicit activities. Because FoP transfers do not involve a transparent monetary exchange within the settlement system, they can, if not properly scrutinized, be exploited for purposes such as money laundering or terrorist financing by obscuring the true purpose or beneficial ownership of the assets. Financial authorities, like the Financial Action Task Force (FATF), continuously update standards to enhance transparency in financial transactions, though these primarily focus on payments rather than FoP securities transfers.² However, robust internal controls, strict adherence to know-your-customer (KYC) regulations, and diligent oversight by compliance departments are critical to mitigate these risks and ensure the legitimate use of FoP mechanisms.

Free of Payment (FoP) vs. Delivery Versus Payment (DvP)

Free of payment (FoP) and delivery versus payment (DvP) are two fundamental methods for settling securities transactions, distinguished by the presence or absence of a linked cash exchange.

DvP is considered the standard and safest method for settling buy and sell trades, as it guarantees that the delivery of securities occurs if, and only if, the corresponding payment is made, and vice versa.¹ FoP, conversely, is applied in specific scenarios where the monetary aspect of the transaction is either non-existent or settled independently. Both methods are critical components of modern custody and settlement systems.

FAQs

What is the main difference between FoP and a regular stock trade?

The main difference is the money component. A regular stock trade is a "delivery versus payment" (DvP) transaction, meaning you pay cash for the shares, and the shares are delivered to you simultaneously. With a free of payment (FoP) transfer, only the shares move; no cash is exchanged as part of that specific transfer.

When would a free of payment transfer be used?

FoP transfers are used for various reasons where cash isn't exchanged for the securities. Common uses include moving shares between your own accounts at different brokers, gifting shares to someone, returning borrowed shares in a securities lending agreement, or receiving shares as part of a company's corporate action, like a stock split or dividend.

Are FoP transfers safe?

FoP transfers are generally safe when conducted between trusted parties and through regulated financial institutions. However, they carry a higher inherent delivery risk than DvP transactions because there's no simultaneous exchange of cash to ensure the other side of a transaction is fulfilled. It's crucial for participants to have clear agreements and robust internal controls.

Do I need to report FoP transfers for tax purposes?

While no cash changes hands in an FoP transfer, the transfer of ownership of securities may still have tax implications. For instance, gifting shares might trigger gift tax rules, and receiving shares from an employer as part of compensation would be taxable income. It is always advisable to consult with a tax professional regarding your specific situation involving any securities transfers.

Can I transfer any security using FoP?

Generally, most types of securities, including equities, bonds, and mutual funds, can be transferred using the FoP method. However, the exact process and any limitations may vary depending on the financial institution, the type of security, and the jurisdiction's regulations.