9.8 Clearing and settlement Flashcards
What happens once a deal has been struck and the terms agreed?
The transaction must then be settled.
What is settlement?
Settlement is the process of organising payment and delivery of the security, and is the point at which legal title changes hands.
Explain CREST.
CREST is an electronic settlement and registration system operated by Euroclear UK and Ireland and is used for the settlement of a wide range of corporate and government securities, including those traded on the London and Irish Stock Exchanges. CREST is the Central Securities Depositary (CSD) for the UK and for Ireland. CREST also settles money market instruments and funds, plus a variety of international securities.
In what forms can investors hold their securities in the CREST environment?
In the CREST environment, investors are able to hold their securities in dematerialised (electronic) and certificated (paper) form. CREST provides book entry transfer for dematerialised stock, as well as the ability to facilitate certificated transactions.
What kind of settlement system does CREST operate?
CREST operates a delivery vs. payment (DvP) settlement system. This means that it records changes in legal title and organises payment simultaneously. A delivery vs. payment (DvP) settlement system lowers settlement risk.
How does CREST handle stamp duty reserve tax?
CREST calculates stamp duty reserve tax on all relevant transaction on the settlement date, and the tax authorities collect SDRT (on dematerialised transactions) via CREST.
Why does CREST have links to company registrars?
To inform the registrar of any change in ownership of securities.
What is the standard settlement time for UK equities and corporate bonds held within CREST?
Two business days (T+2).
What is the standard settlement time for UK government gilts held within CREST?
One business day (T+1)
Is the use of CREST mandatory?
No!
How is a settlement made outside CREST?
Settlement can be achieved outside CREST by a paper based method. The seller would complete a stock transfer form and send it with the share certificate to the buyer. The buyer would then send these forms to the company registrar who will cancel the old share certificate and issue a new one. This process is lengthy.
What happens to ALL securities traded on the SETS order book?
They must be routed through a central counterparty (CCP) to clear the trades.
Describe the novation process.
Clearing involves an organisation becoming counterparty to both buyer and seller of the trade. This effectively breaks the initial trade into two separate trades.
In doing so the central counterparty (CCP) is guaranteeing settlement of the trade and eliminating default risk for the buyer and seller. This also protects the anonymity of the investors involved as they will never know the identity of the participant on the other side of the trade.
The process is known as novation.
Does the risk management central counterparties provide come free of charge?
No! Central counterparties charge for their services.
What are the central counterparties the LSE offers members the choice of?
LCH.Clearnet or SIX X-Clear.
In which market is the clearing of trades more important?
Derivatives markets
What is traded on derivatives markets?
Futures (or forwards) and options
Why is a derivative called a derivative?
It derives its value from the price of an asset (the underlying) that an investor has the obligation or right to buy or sell.
What is a future?
A future is an agreement to buy or sell a specified quantity of a specified asset on a fixed future date at a price agreed today.
What is a forward?
A forward is a name for a future when it is traded over-the-counter (OTC).
What is an option?
An option is a right to buy (a call option) or a right to sell (a put option) a specified quantity of a specified asset on a fixed future date at a specified price.
What classification is given to futures, options and derivatives by regulator such as the FCA?
Risky or ‘complex’ investments
Why is their an added risk when investing in options, futures and derivatives?
One of the reasons for this added risk is that they are highly geared or leveraged, allowing exposure to an asset at only a small proportion of the asset’s price. These high levels of gearing mean that the profit or loss made occurs at a much greater rate than if the investor had invested in the asset to which the derivative relates.
Explain counterparty default risk or credit risk and explain how central counterparties help to mitigate this risk.
For example, with a future an investor can agree to buy a particular asset, let’s say a bond, on a fixed future date for an agreed price, let’s say £100. This agreement becomes a contractual obligation, but in its purest sense no money actually exchanges hands until the fixed future date. This leaves the seller on the other side of the agreement exposed to the risk of the buyer not paying (counterparty default risk or credit risk).
If the price of the bond falls to £90, this makes it even less attractive for the buyer to fulfil their obligation of paying £100 and exposes the seller to further risk.
If, however, the price of the bond rises to £110 it now becomes unattractive for the seller to deliver at £100, exposing the buyer to the risk of counterparty default.
To help manage this exposure to counterparty default risk, exchanges will appoint a central counterparty to novate these trades and collect guarantees, in the form of margin, from the participants. The margin collected ensures that the participants involved can meet the obligations they face, and protects the other side of the agreement from loss if the default occurs.
Define counterparty risk?
Counterparty risk is the risk that, once a contract has been agreed between two parties, at least one of the parties will not meet their obligations.
Who is the risk of counterparty default managed by in most exchange-traded contracts?
A clearing house acting as a central counterparty.