9.8 Clearing and settlement Flashcards

1
Q

What happens once a deal has been struck and the terms agreed?

A

The transaction must then be settled.

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2
Q

What is settlement?

A

Settlement is the process of organising payment and delivery of the security, and is the point at which legal title changes hands.

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3
Q

Explain CREST.

A

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.

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4
Q

In what forms can investors hold their securities in the CREST environment?

A

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.

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5
Q

What kind of settlement system does CREST operate?

A

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.

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6
Q

How does CREST handle stamp duty reserve tax?

A

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.

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7
Q

Why does CREST have links to company registrars?

A

To inform the registrar of any change in ownership of securities.

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8
Q

What is the standard settlement time for UK equities and corporate bonds held within CREST?

A

Two business days (T+2).

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9
Q

What is the standard settlement time for UK government gilts held within CREST?

A

One business day (T+1)

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10
Q

Is the use of CREST mandatory?

A

No!

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11
Q

How is a settlement made outside CREST?

A

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.

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12
Q

What happens to ALL securities traded on the SETS order book?

A

They must be routed through a central counterparty (CCP) to clear the trades.

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13
Q

Describe the novation process.

A

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.

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14
Q

Does the risk management central counterparties provide come free of charge?

A

No! Central counterparties charge for their services.

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15
Q

What are the central counterparties the LSE offers members the choice of?

A

LCH.Clearnet or SIX X-Clear.

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16
Q

In which market is the clearing of trades more important?

A

Derivatives markets

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17
Q

What is traded on derivatives markets?

A

Futures (or forwards) and options

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18
Q

Why is a derivative called a derivative?

A

It derives its value from the price of an asset (the underlying) that an investor has the obligation or right to buy or sell.

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19
Q

What is a future?

A

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.

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20
Q

What is a forward?

A

A forward is a name for a future when it is traded over-the-counter (OTC).

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21
Q

What is an option?

A

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.

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22
Q

What classification is given to futures, options and derivatives by regulator such as the FCA?

A

Risky or ‘complex’ investments

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23
Q

Why is their an added risk when investing in options, futures and derivatives?

A

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.

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24
Q

Explain counterparty default risk or credit risk and explain how central counterparties help to mitigate this risk.

A

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.

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25
Q

Define counterparty risk?

A

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.

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26
Q

Who is the risk of counterparty default managed by in most exchange-traded contracts?

A

A clearing house acting as a central counterparty.

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27
Q

What is the two-fold role of the clearing house?

A
  1. To become the legal counterparty to both sides of the original transaction
  2. To guarantee the performance of both sides of the contract. The main clearing house in the UK is ICE Clear Europe.
28
Q

How do clearing houses act as registrars to the marketplace?

A

Clearing houses act as registrars to the marketplace by recording details of all matched trades. Details of trades are passed electronically to a clearing house via some form of electronic communication system.

29
Q

Describe principal to principal.

A

A clearing house guarantees its members’ obligations to the clearing house. However, this guarantee does not extend to any clients of a member. If a client of a clearing member defaults, the member has no recourse to the clearing house. This guarantee structure is known as principal to principal.

30
Q

How does the clearing house regulate firms to minimise member default?

A

Understandably, the clearing house does not want just any firm becoming a clearing member as it will be exposed to losses if a clearing member defaults. The clearing house therefore imposes minimum criteria on capital adequacy and systems requirements for its clearing members.

31
Q

How does the clearing house seek to minimise its exposure to loses via member defaults?

A

As the clearing house acts as central counterparty to everyone in a particular derivative market, it is exposed to the risk of investors defaulting. The clearing house therefore will put mechanisms in place to safeguard itself. These mechanisms may include a default fund provided by members (as in the case of ICE Clear Europe), default insurance through, for example, the Society of Lloyd’s and the requirement for its members to pay margin.

32
Q

Define margin.

A

Margin covers the clearing house against the risks it faces when acting as central counterparty to a transaction.

33
Q

What is margin always payable on?

A

Margin is always payable on ‘contingent liability’ transactions. For example, on derivative transactions, these are transactions where investors can lose more than their initial investment: Long and short futures positions and short option positions.

34
Q

Why are the rules on margin different for long option positions?

A

The potential loss is limited to the premium which is paid by the investor on the agreement.

35
Q

Name two different types of margin.

A
  • Initial margin
  • Variation margin
36
Q

What is initial margin?

A

Initial margin is described as a returnable good faith deposit. It represents the worst probable loss that could be made on a bad day (as opposed to the worst possible loss, which could be unlimited).

36
Q

Why does the clearing house hold the initial margin?

A

To cover the risk of a clearing member failing to meet a variation margin payment. If the clearing member defaults, the clearing house should have enough initial margin to cover the shortfall.

37
Q

Is the risk of default static or dynamic?

A

As the prices of underlying assets are constantly changing, the risk to the clearing house of a member defaulting also changes.

38
Q

Why might members receive additional initial margin bills even if they have not opened any new positions?

A

Their existing open positions have become more risky.

39
Q

What happens if there is a short-term increase in volatility?

A

We have seen in recent years sudden increases in volatility in a particular investment or in the market as a whole. Sometimes, however, this is seen as a short-term change. If the change is deemed by the clearing house to be short-term, instead of increasing the initial margin it will call intra-day margin to cover this volatility.

40
Q

When is initial margin paid out?

A

Initial margin is paid when the contract is opened and return when the obligations in the contract are met, or the contract is closed out.

41
Q

What does variation margin account for?

A

The previous day’s gains and losses made on open derivative positions.

42
Q

Who is variation margin paid by and received by?

A

Variation margin is paid by the loser of one open position and received by the winner of another open position.

43
Q

When and how is the variation margin paid?

A

The payment is made by the next business day through a protected payment system. The ‘losers’ pay variation margin to the clearing house each day. In turn, the clearing house forwards the margin onto the day’s ‘winners’.

44
Q

How is the transfer of variation margin made?

A

As all clearing members have accounts with the clearing house, the transfer is made simply by debiting the loser’s account and crediting the winner’s account. This requires each clearing member to hold an account with a clearing house approved bank so that funds can be securely paid into or withdrawn from the margin account.

45
Q

What happens if a member fails to pay their variation margin?

A

Failure to pay variation margin by the due time will result in the clearing house closing out the member’s positions and using their initial margin to cover the previous day’s losses. Any surplus will be returned to the clearing member.

46
Q

How are Title Transfer Collateral Agreements (TTCAs) used in margining derivative trades?

A

Margining derivative trades is where firms collect margin from clients to allow the trade to be opened, and then use title transfer collateral arrangements, the firm does not need to treat this as client money. Instead, it is considered part of the firms working capital. In effect, these arrangements transfer full ownership of the client’s money to the firm.

47
Q

What happens if a firm goes into liquidation?

A

This provides no guarantee on the return of money. If the firm fails and goes into liquidation, the client will be treated as a general creditor.

48
Q

Which legislation permits Title Transfer Collateral Agreements?

A

This is prohibited under the FCA Client Asset Rules when conducting activities for retail clients.

49
Q

What must firms do when they use a title Transfer Collateral Agreement?

A

Where the Title Transfer Collateral Agreements is used, firms must ensure that there is a full written agreement with the client in place setting out the terms and conditions of the arrangement. The risk of Title Transfer Collateral Agreements and the rationale behind using Title Transfer Collateral Agreements with the client would also need to be disclosed.

50
Q

Why are international markets becoming increasing attractive to investors?

A

International markets are becoming increasing attractive to investors, both institutional and individual, as it adds to diversification benefits. The access to these markets is also becoming easier. As exchanges adopt electronic order books systems, interconnectedness of these exchanges becomes possible. Also, investments such as depositary receipts, exchange traded funds (ETF) and eurobonds allow investors to get exposure to overseas markets in their own currency.

51
Q

How is trading in the EEA by UK investors classified from a regulatory perspective?

A

Trading in the EEA is considered less risky for UK investors from a regulatory perspective, as many of the regulations in the financial services have been harmonised through various directives, such as MiFID, EMIR, etc. This means the mechanisms for trading and settlement and delivery will be very similar to those in the UK.

52
Q

What is the main exchange in Germany and France?

A

The main exchange in France is Euronext and in Germany, Deutsche Borse. However, many of the stock trading on these and other European exchanges can be accessed through European Quoting System on the LSE.

53
Q

In what ways is trading in the US similar to the UK?

A

Trading in the US is also very similar to the UK, in that it is a very liquid and heavily regulated market.

54
Q

Where does trading of equities take place in the US?

A

Trading of equities takes place on the main markets in the US such as: the New York Stock Exchange (NYSE), the National Association of Securities Dealers Automatic Quote System (Nasdaq).

55
Q

What is the largest US equity market?

A

NYSE

56
Q

How is trading on the NYSE conducted?

A

Trading is undertaken by member firms’ floor brokers and local brokers, who trade through designated market makers (DMM). Specialists are assigned specific stocks and act in a way which maintains an orderly market. They quote two-way prices throughout the day. Orders are passed to specialists for matching using the Universal Trading Platform (UTP), the UTP can also work in a similar way to the LSE’s SETS order book.

57
Q

What kind of market is the NYSE, primarily?

A

The NYSE is primarily a domestic market. International trading is confined to American depositary receipts (ADRs), which facilitate the trading in the US of shares in non-US companies.

58
Q

What is Nasdaq?

A

Nasdaq is an electronic market for second line stocks.

59
Q

What are emerging markets?

A

Emerging markets are considered to be those that are not fully developed, including much of Asia, Africa and South America.

60
Q

What is the benefit of investing in emerging markets?

A

The key benefits of these markets is the potential for economic growth and the fact that the economic cycles of these nations tend to differ greatly form the developed nations – often referred to as decoupling.

61
Q

What are the disadvantages of investing in emerging markets?

A

Key disadvantages are the potential volatility in the markets, as much of the value is based on expectation, and the less rigorous regulation of the participants and the infrastructure. This is one of the key reasons many investors choose to access these markets via ETF and depositary receipts.

62
Q

For investors investing internationally, using a local depositary in each country will give the investor a market expert, but can be problematic. List 3 difficulties of this.

A
  • Domestic exchanges and securities only
  • Communication problems due to language
  • Local regulations governing custody may differ
63
Q

Many investors that have large international investment portfolios may use an international central securities depositary (ICSD). What are 4 things these ICSDs, such as Euroclear, Clearstream and the DTCC, offer?

A
  1. A one-stop shop for all activities
  2. Global membership
  3. Consolidated reporting
  4. Economies of scale
64
Q

What are some key points in relation to settlement times?

A

Although the G30 consultative group for international economics recommend good practice for settlement times, e.g. T+3 for equities, countries tend to have differing settlement times.

We should assume for the exam that settlement in the UK and rest of Europe will be T+2 for most asset classes. There are, however, some exceptions to this.

65
Q

Summarise the exceptions to typical settlement times. List the:

  • Country/region
  • Instruments settled
  • Settled period
  • System name
A
  • In the UK Listed equities and corporate bonds are settled T+2 via Euroclear UK and Ireland.
  • In the UK Government bonds (gilts) are settled T+1 through a cash settlement via Euroclear UK and Ireland.
  • In the EU (particularly Germany) listed German equities are settled T+2 via Clearstream.
  • In the EU (particularly Germany) International bonds are settled T+2 via Clearstream/Euroclear.
  • In the US listed equities are settled T+2 via a Depositary Trust Clearing Corporation (DTCC).
  • In the US government bonds are settled T+1.
  • In Japan listed equities and convertible bonds are settled T+2 via Japan Securities Depositary Center (JASDEC)