Bad delivery
Securities that are delivered for settlement but rejected by the depository for technical reasons such as incorrect signatures, names or details — treated like a short delivery and closed out through auction.
In plain language
A seller's job at settlement is to deliver the shares. There are two ways that can go wrong:
- Short delivery — the shares are not delivered (fully or partly) on the settlement day.
- Bad delivery — the shares are delivered, but the depository rejects them for technical reasons such as incorrect signatures, names or details.
The workbook says a bad delivery "has to be rectified". From the buyer's point of view the two failures are the same: in both cases the buyer "has paid good money, and needs to receive delivery of shares". So the clearing corporation treats them the same way — through an auction.
How it works
The process in section 4.6.5 (Short Delivery and Payment):
- Close-out value. The clearing member responsible pays the clearing corporation an amount equal to the value of the shortfall: the number of shares short × the last closing price on the settlement day.
- Auction. The clearing corporation buys the required shares through an auction trade conducted on the trading system, and delivers them to the buyer.
- Make good the difference. Any difference in the price paid to acquire the shares in the auction has to be made good by the clearing member.
The buyer is kept whole throughout; the cost of the failed delivery lands on the member whose side failed.
Where this sits: the clearing corporation is the counterparty to all trades and guarantees settlement, and margins are collected precisely because a seller may not deliver on the due date. Funds shortages on the buy side have a separate regime — a penal charge on the outstanding amount, withdrawal of trading or clearing facility until made up, and, for repeat defaulters, a "funds shortage collateral".
The formula
Amount payable at close-out = Shares short (or rejected) × Last closing price on settlement day
Clearing member's extra cost = (Auction price − Last closing price) × Shares, if positive
A worked example
Illustrative numbers. A client of broker PQR sells 500 shares of Sunrise Pharma. On settlement day the shares reach the depository, but the transfer is rejected because the name details do not match. It is a bad delivery.
The last closing price on the settlement day is Rs 240.
Close-out amount paid by clearing member = 500 × Rs 240 = Rs 1,20,000
The clearing corporation runs the auction and buys 500 shares at Rs 252:
Auction cost = 500 × Rs 252 = Rs 1,26,000
Difference = Rs 1,26,000 − Rs 1,20,000 = Rs 6,000
The Rs 6,000 difference is made good by the clearing member, who will look to recover it from PQR and its client. The buyer, meanwhile, receives 500 shares and never sees the problem.
Had the auction price been below Rs 240, the Rs 1,20,000 already paid would have more than covered the purchase — which is exactly why the close-out is set at the settlement-day closing price.
Why NISM asks about it
Chapter 4 (Secondary Markets) defines bad delivery in its settlement section — "if a security, that is delivered, is rejected by the depository for technical reasons such as incorrect signatures or names or details it is a bad delivery and has to be rectified" — and again in section 4.6.5, where short and bad delivery share the auction process. Expect a distinction question (short delivery = not delivered; bad delivery = delivered but rejected) and a process question (auction; valuation at last closing price; difference borne by the clearing member).
Common exam traps
- Bad delivery ≠ short delivery. Short is not delivered; bad is delivered but rejected by the depository.
- Both go to auction — a non-delivered security "comes into auction", and bad delivery is handled the same way.
- Close-out is at the last closing price on the settlement day, not the original trade price.
- The auction price difference is borne by the clearing member, not the buyer and not the clearing corporation.
- Rejected for technical reasons — incorrect signatures, names or details. A price dispute is not a bad delivery.
- Funds shortage is a separate regime (penal charge, facility withdrawn, funds shortage collateral for repeat defaulters).
Where this is taught
- Series VI · Chapter 2: Introduction to Depositoryintroduced here
- Series XII · Chapter 4: Secondary Marketsintroduced here
Related terms
- Buy-in auctionThe auction a clearing corporation runs through the exchange system on settlement day to buy shares a selling member failed to deliver, so the buying member still receives them.
- Close outSettling an undelivered sale in cash instead of shares: the defaulting seller is charged at a penal close-out price, used when an auction finds no sellers or is not held at all.
- Pay-inThe leg of settlement in which clearing members hand over what they owe: funds into the clearing corporation through the clearing bank, and securities into its pool account through the depository.
- Clearing corporationThe entity that steps between every buyer and seller in the derivatives segment by novation, becoming the counterparty to both sides and guaranteeing that the trade settles.
- DepositoryAn institution that holds investors' securities in electronic form and provides the services needed to transact in them — the securities equivalent of a bank holding money rather than cash.
- MarginThe money a buyer or seller must deposit before a trade is allowed to stand, so that the clearing corporation is covered if they fail to bring in funds or to deliver securities.
- Short deliveryA member's failure to pay in securities, fully or partly, on the settlement day — closed out at the shares' last closing price and made good by the clearing corporation through an auction.
- FungibilityIn the depository, securities of the same class carry no distinctive or certificate numbers — every unit is identical to every other and interchangeable, so title is counted in numbers, not in serial numbers.
- Odd lotA holding of physical securities smaller than the market's standard tradable lot — a problem the workbook says dematerialisation eliminated by reducing the tradable lot to one unit.