Clearing, Settlement and Custody

David Loader

• Publisher: Butterworth-Heinemann
• Year: 2019
• eBook ISBN: 9780128186916
• Edition: 3
• Topic: Business
• Subtopic: Finance
• Index: Business

Clearing, Settlement, and Custody, Third Edition, introduces the post-trade infrastructure and its institutions. Author David Loader reduces the complexity of this environment in a non-technical way, helping students and professionals understand the complex chain of events that starts with securities trading and ends the settlement of cash and paper. The Third Edition examines the roles of clearing houses, central counterparties, central securities depositories, and custodians. The book assesses the impact on workflow and procedures in the operations function at banks, brokers, and institutions. In consideration of technological and regulatory advances, this edition adds 5 new chapters while introducing new case studies and updating examples.- Adds a new chapter while updating all chapters- Adds new case studies and end-of-chapter questions- Introduces current examples to illuminate important points

Chapter 1

The structure of clearing and settlement

Abstract

This chapter introduces the concepts of clearing and settlement. It discusses the process in respect of payments and securities identifying the key systems. The chapter also looks at the evolution of clearing and settlement and the key recommendations that have shaped the processes use today.

The role of the clearing house and an overview of the major providers of central clearing are explored including DTCC, Euroclear and Euroclear Great Britain and Ireland (CREST), Clearstream, LCH Clearnet, TARGET2.

We look at the flow for a transaction through to settlement seeing how each player is involved.

Keywords

Clearing; Settlement; Clearing house; Securities depositories; Payments; Central clearing; G30

Contents

• What is clearing and settlement?
• The clearing house
• Changes in clearing
• Development of the clearing structures
  • In 2006 the G30 published its final monitoring report for global clearing and settlement^a executive summary
  • Interoperability
  • Mitigating risk
  • Improving governance
  • Conclusion
• Objectives of clearing houses

What is clearing and settlement?

An interesting question and one that, on the face of it, could be answered by a simple definition and yet in the financial markets it is often a very little understood but vital process.

For every transaction that takes place in the markets there is a process that concludes the transaction, the finality of settlement. In general terms that will mean some kind of exchange taking place between the two parties to the trade. The exchange may be cash for a security or the netted outcome of more than one transaction, for instance the end result of a purchase and sale or a series of purchases and sales.

Clearing is a term that is easily associated with banking so that we have the “clearing banks.” In this instance the item being “cleared” is money and, historically, cheques. When a cheque is drawn it has a value that is only realized when the receiving bank has presented it to the drawing bank and received the value, hence the term “value date.” As most people know, the time to obtain the value may be three or even more days from the paying into the account of the cheque. Today the somewhat antiquated process of cheques being cleared has been largely replaced by automated processes or electronic banking. The payment systems that allow electronic transfer of money are usually owned and operated by the Central Bank of the country of the currency. Example of payment systems are Fed Wire and CHIPS in the USA, BACS and CHAPS in the UK and TARGET2 for the Euro. There are also other ways of making a payment for example via SWIFT, Paypal or Western Union or in the UK the Faster Payment System (FPS) however with the exception of SWIFT these are generally small or low-value payments.

In the financial markets there is not only cash but also near cash or money market instruments like treasury bills. A transaction in these bills is settled in the UK through the CREST system at Euroclear. Euroclear UK and Ireland (Euroclear) provides via CREST the UK securities settlement service for both money market instruments and also UK and international securities and bonds. This includes equities, bonds, unit trusts and shares in open-ended investment companies (OEICs).

In the USA treasury instruments are cleared via the Government Securities Clearing Corporation (GSCC), securities via the National Securities Clearing Corporation (NSCC) and in Europe via TARGET2Securities (T2S) for euro denominated securities.

So we know that money is cleared and settled in banking and so are securities including treasury instruments, equities, debt as well as commodities and derivatives; although the processes may be very different.

We looked at clearing and settlement in the overview so we can look again at what the two terms mean.

The process of clearing can be defined as:

The preparation through matching, recording and processing instructions of a transaction for settlement.

Settlement can be defined as:

The exchange of cash or assets in return for other assets or cash and transference of the ownership of those assets and cash.

In each market around the world transactions in financial market instruments follow the same basic principle of clearing and settlement. The process of clearing and settlement is often linked with another process, the holding of the records of securities, in electronic form or sometimes in physical form. When this occurs we find a key player in the central securities depositories or CSDs for short. CSDs hold securities centrally on behalf of their members to speed the process of clearing and settlement. This is particularly relevant where physical securities still exist as the selling party does not have to send the securities to the buying party who may be resident overseas. The risk in moving physical securities is the possibility of the loss of the securities. As noted, this is extremely important in the case of for example bearer securities where there is no evidence of ownership recorded. However the markets are always changing and in response to worries about money laundering, bearer instruments in many countries can no longer be issued.

We should also note at this point that CSDs and International Central Securities Depositories (ICSDs) like Euroclear, Clearstream and DTCC only operate in instruments they have approved as “eligible.” We cannot forget that a wide range of instruments cannot be processed via a CSD or for that matter a CCP, for example private equity, which are shares in small unlisted or privately owned companies.

The clearing house

It is important to note that the clearing process is carried out by a designated function, and the organization that performs this function is often called a clearing house. The clearing house operates either completely independently from or to a significant degree as part of the exchanges or market it serves. The responsibility for managing and overseeing the trading process is therefore quite separate from the process of controlling the transactions through to settlement. The clearing house does not make the rules and regulations pertaining to carrying out transactions, but it does establish the rules, in conjunction with the regulator and the exchange, by which its members will clear and settle the business they do.

Fig. 1.1 shows the process associated with an equity transaction on the NYSE whilst Fig. 1.2 shows the process for a trade on NYSE Euronext in Paris.

Fig. 1.1 The process associated with an equity transaction on the NYSE. (From The DSC Portfolio Ltd.)

Fig. 1.2 The process for a trade on NYSE Euronext in Paris. (From The DSC Portfolio Ltd.)

We can see where some of the participant organizations that we have mentioned are located in the trade and post-trade clearing and settlement process, including the CSD and payment systems.

The relationship between the clearing house and its members is that the clearing house settles trades on a net basis between itself and its members. Netting means that bought and sold trades are offset and the cash position across trades is also netted. The opposite to netting is gross settlement, which is where every trade will settle separately. Fig. 1.3 below illustrates this and as we can see not only is netting applied, but also settlement takes place on a delivery versus payment (DVP) process, which again helps to reduce the risk of failed settlement on one side or leg of the trade.

Fig. 1.3 The flow for an OTC transaction. (From The DSC Portfolio Ltd.)

Changes in clearing

We noted in the overview that today, as with so much of the financial markets, change is taking place in the way in which activity on markets is cleared and settled.

Let us recap on this and explore further.

The central clearing counterparty (CCP), essentially a process of not just facilitating settlement but guaranteeing it, is becoming common in securities markets and thus the clearing and settlement of securities is moving towards the same process as that used for derivatives.

In the UK, the London Clearing House (LCH), a major clearer of derivatives for many years, joined with CREST to provide a central clearing process for equities called EquityClear.

In Figs. 1.1–1.3 above we saw the possible relationships between the trading, clearing and settlement and the relationship with the CCP. Note that there need not necessarily be a one-to-one relationship between the trading member as legal entity and either the clearing member or the settlement entity.

We look at the CCP again in more detail later in the book but it is important to remember that the changes in clearing and settlement are impacting on operations teams and, of course, the procedures and controls they use. There are many benefits, as we have already determined of the CCP structure, but there is also a need to ensure that firms and cli...

Table of contents

• Cover image
• Title page
• Table of Contents
• Copyright
• Introduction
• Chapter 1: The structure of clearing and settlement
• Chapter 2: The role of the clearing house, trade repositories and central securities depositories
• Chapter 3: Bond settlement and the role of treasury
• Chapter 4: Equity clearing and settlement
• Chapter 5: Clearing and settlement of derivatives
• Chapter 6: Custody services
• Chapter 7: Securities lending
• Chapter 8: Settlement of portfolio transactions and subscription/redemption of shares and units in investment funds
• Chapter 9: Risk and regulation
• Chapter 10: Developments in clearing settlement and custody—SWIFT, CLS bank, T2S, the development of distributed ledger technology (DLT), Brexit
• Glossary
• Index