Key steps in clearing and settling securities

By Stanley Epstein

The 2008 financial crisis was a real eye-opener when it erupted so un-expectantly and devastatingly in the middle of that year. In turn this led to an absolute panic regarding maintaining financial stability. One of the many ways of keeping financial stability on an even keel is by strengthening the financial infrastructure both at a domestic and international level.

Of the many vital financial infrastructural processes involves is the clearing and settling in the securities trade. As to most laymen this aspect of the financial world remains a bit of a “black box”.

In this short article I take a closer look at the securities clearing and settling process.

Securities clearing and settlement includes several key steps. This includes:

• Confirmation of the terms of the trade by the direct market participants,
• Calculation of the obligations of the counterparties resulting from the confirmation process, known as “clearance”, and
• Final transfer of securities (“delivery”) in exchange for final transfer of funds (“payment”) in order to settle the obligations.

There are a number of different ways that each of these processes or stages can be carried out.

Also there are a number of special services that are supplementary to these activities and that also form a part of the securities industry.

These activities include:

1. Confirmation of trade details. This occurs between direct market participants and indirect market participants (institutional investors and foreign investors or their agents). This first step in the clearing and settlement process is to make certain that the counterparties to the trade (the buyer and the seller) agree on the terms, that is, the security involved, the price, the amount to be exchanged, the settlement date and the counterparty. This process of trade confirmation can take place in a number of different ways. The trading mechanism itself often determines how it takes place.
2. Clearance. Clearing occurs after trades have been confirmed. Clearing is the process involving the computation of the obligations of the counterparties to make deliveries or to make payments on the settlement date. The settlement instructions are then communicated to central securities depositories (CSD) and to custodians that many investors use for the safekeeping of their securities. Clearance usually occurs in one of two ways. Many systems calculate the obligations for every trade individually. This means that clearance occurs on a gross or trade-for-trade basis. In other systems, the obligations are subject to netting. In some markets, a central counterparty (CCP) interposes itself between the two counterparties to a securities trade, taking on each party’s obligation in relation to the other. By achieving netting of the underlying trade obligations, the use of a CCP reduces credit risk (both replacement cost and principal risk) and liquidity risk for the trade counterparties. Netting arrangements are becoming more common in securities markets with high volumes of trades because properly designed netting significantly reduces the gross exposures in such markets.
3. Delivery versus Payment. This relates to the linkage of transfer instructions by a securities transfer system and a funds transfer system and often involves several stages during which the rights and obligations of the buyer and the seller are significantly different. Very often accounts may have been debited or credited, but the transfer remains provisional, and one or more parties may hold the right by law or agreement to cancel the transfer. If the transfer can be rescinded by the sender of the instruction, the transfer is said to be revocable. Even if the instruction is irrevocable, if a party such as the system operator or a liquidator can rescind the transfer, it is considered only provisional. Only at the stage at which the transfer becomes final, that is, an irrevocable and unconditional transfer, is the obligation discharged. Final transfer of a security by the seller to the buyer constitutes delivery, and final transfer of funds from the buyer to the seller constitutes payment. When delivery and payment have occurred, the settlement process is complete.
4. Registration. Many settlement systems have associated “registries” in which the ownership of securities is listed in the records of the issuer. Registrars typically assist issuers in communicating with securities owners about corporate actions, dividends, etc.
5. Safekeeping or custody. This is an ongoing part of the securities settlement process after the final settlement of a trade. While securities are normally held in a CSD, many of the ultimate holders of securities are not direct members of these depositories. Rather, investors establish “custody” relationships with depository members, who provide safekeeping and administrative services related to the holding and transfer of the securities. Custodians keep records of securities holdings on behalf of investors, monitor the receipt of dividends and interest payments and corporate actions (for example share repurchases, mergers and acquisitions). So even while the principles involved in the clearing and settling of securities may be simple and fairly easily understood, their inner working are far more complex. Local and international permutations can be highly complex in terms of process, practice and principle.

This is just a “slice” so to speak of the inner workings of the securities clearing and settlement process. The smallest slip-up, the smallest omission can lead to absolute disaster.

Sometimes referred to as the ”plumbing of the financial system” these processes are critical to ensuring that our 21 century financial systems function as intended.

The key steps in clearing and settling in the securities trade

Stanley Epstein - Principal Associate - Citadel Advantage

We have all been concerned these past few years about the ongoing financial crisis which erupted so suddenly and devastatingly in the middle of 2008. Much concern has been expressed regarding maintaining financial stability. One of the many ways of doing this is by strengthening the financial infrastructure both at a domestic level or internationally.

One of these vital financial infrastructural processes involves the clearing and settling in the securities trade. In this short article we will take a closer look at the securities clearing and settling process.

Securities clearing and settlement includes several key steps. This includes:

• Confirmation of the terms of the trade by the direct market participants, 
• Calculation of the obligations of the counterparties resulting from the confirmation process, known as “clearance”, and 
• Final transfer of securities (“delivery”) in exchange for final transfer of funds (“payment”) in order to settle the obligations. 

There are a number of different ways that each of these stages can be carried out.

Also there are a number of special services that are supplementary to these activities and that also form a part of the securities industry.

These activities include:

1. Confirmation of trade details. This occurs between direct market participants and indirect market participants (institutional investors and foreign investors or their agents). This first step in the clearing and settlement process is to make certain that the counterparties to the trade (the buyer and the seller) agree on the terms, that is, the security involved, the price, the amount to be exchanged, the settlement date and the counterparty. This process of trade confirmation can take place in a number of different ways. The trading mechanism itself often determines how it takes place.
2. Clearance. Clearing occurs after trades have been confirmed. Clearing is the process involving the computation of the obligations of the counterparties to make deliveries or to make payments on the settlement date. The settlement instructions are then communicated to central securities depositories and to custodians that many investors use for the safekeeping of their securities. Clearance usually occurs in one of two ways. Many systems calculate the obligations for every trade individually. This means that clearance occurs on a gross or trade-for-trade basis. In other systems, the obligations are subject to netting. In some markets, a central counterparty interposes itself between the two counterparties to a securities trade, taking on each party’s obligation in relation to the other. By achieving netting of the underlying trade obligations, the use of a CCP reduces credit risk (both replacement cost and principal risk) and liquidity risk for the trade counterparties. Netting arrangements are becoming more common in securities markets with high volumes of trades because properly designed netting significantly reduces the gross exposures in such markets.
3. Delivery versus Payment. This relates to the linkage of transfer instructions by a securities transfer system and a funds transfer system and often involves several stages during which the rights and obligations of the buyer and the seller are significantly different. Very often accounts may have been debited or credited, but the transfer remains provisional, and one or more parties may hold the right by law or agreement to cancel the transfer. If the transfer can be rescinded by the sender of the instruction, the transfer is said to be revocable. Even if the instruction is irrevocable, if a party such as the system operator or a liquidator can rescind the transfer, it is considered only provisional. Only at the stage at which the transfer becomes final, that is, an irrevocable and unconditional transfer, is the obligation discharged. Final transfer of a security by the seller to the buyer constitutes delivery, and final transfer of funds from the buyer to the seller constitutes payment. When delivery and payment have occurred, the settlement process is complete.
4. Registration. Many settlement systems have associated “registries” in which the ownership of securities is listed in the records of the issuer. Registrars typically assist issuers in communicating with securities owners about corporate actions, dividends, etc.
5. Safekeeping or custody. This is an ongoing part of the securities settlement process after the final settlement of a trade. While securities are normally held in a CSD, many of the ultimate holders of securities are not direct members of these depositories. Rather, investors establish “custody” relationships with depository members, who provide safekeeping and administrative services related to the holding and transfer of the securities. Custodians keep records of securities holdings on behalf of investors, monitor the receipt of dividends and interest payments and corporate actions (for example share repurchases, mergers and acquisitions).

So even while the principles involved in the clearing and settling of securities may be simple and fairly easily understood, their inner working are far more complex. Local and international permutations can be highly complex in terms of process, practice and principle.