Chapter 10 (4marks) - clearing and settlement Flashcards
Difference between Clearing & Settlement is the process of formally agreeing the obligations on each party to a transaction, and settlement is the process of transferring ownership of securities from the seller to the buyer, and transferring cash from the buyer to the seller
Clearing = the process of formally agreeing the obligations on each party to a transaction,
settlement = the process of transferring ownership of securities from the seller to the buyer, and transferring cash from the buyer to the seller. Settlement in the UK is done via CREST.
So far, we have looked at how securities are first issued in the primary market and then subsequently traded in the secondary markets. This next chapter will cover how the clearing and settlement process works i.e. when and how we pay for the securities that we have bought and the different ways in which they can be held, in both the UK and international markets.
10.1: Clearing and Settlement
When shares and bonds are issued, they can be either registered or bearer securities.
registered =
The investor’s name appears on the share register.
Share certificates may be issued with the shareholder’s name on.
Uncertificated holdings will have no physical certificate.
Ownership is transferred by updating the electronic records held at the central securities depository and the share register.
Bearer =
The owner of the shares is whoever holds the certificate.
Ownership is transferred by passing the certificate to the new owner.
If the share certificate is lost, so is your investment.
Think of them like a £10 note. Whilst you’ve got it, it’s yours!
Bearer shares are very rare these days. Most have been converted to registered shares, due to the rise of their use in money laundering activities and the massive risk of losing the physical certificates.
Nominee accounts
Firms will establish a nominee company for the purpose of holding and administering client’s assets. The nominee is the legal owner of the assets which they hold in safekeeping on behalf of their clients who are the beneficial owners.
There are two different types of nominee accounts: pooled or omnibus accounts, or designated accounts.
omnibus accounts =
designated accounts =
Omnibus accounts = Individual clients are pooled together and held in one nominee account,
Advantage = Client orders can be aggregated and only one transaction needs to be settled for many clients.
Disadvantage = if the nominee defaults, then investors only have claim to the pool of assets and could be affected by any shortfall.
Designated account = The nominee has unique account names for each client e.g. ABC Nominees Account 1, Account 2 and so on.
Advantages = Easy to identify the beneficial owners
Easier to see who holds what in the event of the nominee defaulting.
Disadvantages = administratively it is more cumbersome for the investment firm.
10.1.2: Clearing and Settlement process
There are three stages, known collectively as clearing and settlement:
Confirmation
Clearing
Settlement
Tell me about each
GILTS settle on a T+1 basis
Corporate bonds & equities trade on a T+2 basis
10.1.6: Central Securities Depositories (CSDs) (for example CREST)
The CSD holds an electronic record of share ownership (along with the share register held by the issuer) which enables ownership of shares to be transferred by book-entry transfer.
Every country has its own CSD for settling domestic trades. There are also two international CSDs (ICSDs) that settle international trades.
In addition to settling transactions by book-entry and on a DvP basis, the main functions of a CSD include (remember ICSD):
Immobilisation: holding share certificates in a vault, so no physical movement when ownership is transferred.
Corporate actions: processing corporate actions in accordance with the issuer.
Safekeeping of securities.
Distribution of income from the issuer.
They will also look to liaise with CSDs in other countries to facilitate any cross-border transactions.
settlement in the UK is via CREST’ the CSD for the UK.
10.1.7: Trade failures
What happens when a trade fails?
Sometimes a trade fails, and settlement does not take place on the intended settlement date.
This can be for a variety of reasons; maybe there was a problem with inputting the trade details and it didn’t match, or the buyer doesn’t have sufficient cash, or the seller has insufficient stock.
Continued
What happens in this case?
Let’s say Chloe doesn’t have enough cash to pay for the stocks. What options are open for John?
He could wait until Chloe finds the cash and then charge her a penalty payment for late settlement, or
He could institute selling-out procedures at the LSE. This involves selling the shares to another buyer and passing any additional costs back to Chloe.
Alternatively, what if Chloe has the money but John doesn’t have the shares to deliver?
She could wait until John has the shares and charge him a penalty payment, or
She could institute buying-in procedures where she will buy the shares from another seller and pass on any additional costs to John.
10.2: UK Settlement
10.2.1: CREST structure
How does CREST work
Trades can only be settled through CREST members. Each member has their own participant ID and at least one member ID. Within each member account, there will be different securities accounts which record the holdings in the shares of different companies. There are 3 categories of membership:
Direct members
Sponsored members
Nominee members
10.2.2: Settlement in Crest
There are 4 stages to settlement in CREST.
Trade Matching
Stock Settlement
Cash Settlement
Register Update
Tr
10.2.3: Shares held in certificated form
For shares that are held in certificated form then the process is a little more convoluted.
The seller will need to complete a CREST stock transfer form, and this will be deposited along with the physical share certificate (known together as a deposit set) at a regional CREST counter. An electronic CREST record will then be created.
The deposit set will be sent to the company registrar who will delete the securities registered in the name of the seller and input the name of the buyer on the share register.
The securities will be credited to the CREST account so that they trade can settle electronically. The new owner will then hold the shares in electronic form.
This process takes much longer and so trades in certificated form settle in T + 10.
It is also possible for the reverse to happen if an investor wishes to hold shares in certificated form rather than electronic form.
This process takes much longer and so trades in certificated form settle in T + 10.
10.2.4: Stamp duty reserve tax (SDRT) and stamp duty
SDRT is payable on the purchase of shares in electronic form via CREST. It is charged at 0.5% and rounded up to the nearest penny. AIM shares, ETF shares, and the LSE High Growth segment are exempt from SDRT.
Stamp duty (rather than SDRT) is chargeable on the purchase of shares in certificated form, but only if the value is over £1,000. The rate of 0.5% is the same but it is rounded up to the nearest £5.
AIM shares, ETF shares, and the LSE High Growth segment are exempt from SDRT.
10.3: International Settlement
10.3.1: Operational risks
Dealing in overseas markets brings about some operational risks. Some of these are fairly obvious, such as currency risks, but there are other factors that need to be taken into considerations.
For example:
Do we need to be authorised to trade in overseas markets?
Are there any restrictions in place for foreign investors?
Are there different rules compared to UK exchanges that we need to be aware about, such as short selling rules?
There may be delays due to time differences either between placing orders and them being executed or in the settlement of trades.
We also need to ensure that we make arrangements to safeguard our assets by appointing a local / global / regional custodian.
What are the penalties for settlement delays? Will settlement delays result in compulsory buy ins?
How will the company communicate any corporate actions?
10.3.2: International settlement (LIKELY TO BE IN EXAM!!!)
The most important things to know in this section for the J12 exam are the exchanges, depositories and settlement periods for each country shown below. (LOOK AT GRAPH)
Take some time to learn these, as questions are highly likely in your exam.
10.4: Client Assets and Money
Let’s say that you use the services of an investment firm. You invest a substantial amount, and they invest this in a variety of different securities as well as keeping a bit aside in cash. They agree to hold the assets and money on your behalf. How do you feel about this? A little nervous maybe? What happens if the company becomes insolvent? Will your assets disappear along with those of the investment firm?
the answer is no, they don’t.
The FCA require that all authorised firms that are holding client assets or money must put arrangements in place to safeguard those assets.
Rules are laid down in CASS – the FCA’s Client Assets Sourcebook that ensure that client assets are protected against insolvency of an authorised firm or from the misuse of client assets by the firm or one of its employees. Clients must also be informed of the arrangements that are in place.
10.4.1: Client money
Client Money = Client money must be segregated from any other money held by the firm. The account must have a distinct title so that it is easy to distinguish it from other accounts.
The bank must send confirmation of this arrangement before funds can be deposited.
10.4.2: Client Assets
Firms can safeguard assets under its own control or by using a custodian. Regular reconciliations between the firm and custodians / nominees must take place as frequently as is necessary and any shortfall that is the firm’s responsibility should be made good by the firm.
Both above do not relate to DvP transactions.
10.5: Custodians
Firms can choose to use either a:
Local custodian
Regional Custodian (Europe)
Global Custodian
the primary function of a custodian is to look after investor’s assets. They must ensure that the assets are held entirely separately from their own and that investments are only released following instruction from the client.
Local custodian = provides services in the local domestic market. Firms can become members of the CSD in each of the markets that it invests in.
Regional custodian = Alternatively, they could employ the services of a regional custodian who will operate across the markets in a particular region. They won’t have quite as much knowledge of the local market, but it would likely be more cost effective.
Global custodian = who provides services across all markets. They may do so by having a large network of global branches or by employing a sub-custodian such as a local or regional custodian. The custody market is dominated these days by a small group of global custodians, who are mainly divisions of the large investment banks.
10.6: Stock Lending and Prime Brokerage
Why would someone lend their stocks / securities to someone else?
The simple answer is the person lending the stocks will earn something from it, whilst the person borrowing them will be able to use them to achieve a particular aim.
10.6.1: Stock lending
Stock lending serves several purposes:
If a trade fails because there is a shortage of stock to deliver, this can have a huge knock-on effect on the market. The stock lending process helps firms who have found themselves ‘short’ on stock to be able to borrow it to make good their settlement obligations. If we have an active stock lending market, then this should reduce the number of trade fails in that market.
It allows investors to be able to use securities that they are not intending to sell, to earn a fee from them.
If an investor believes that the market is going to fall, then they can employ a short selling strategy, whereby they sell securities they don’t own in the hope that the price will fall, and then hopefully buy them back at a cheaper price.
Let’s say a hedge fund decides to short XYZ shares and a pension fund is willing to lend them out.
The pension fund lends the shares in XYZ to the hedge fund for a set period.
Although we use the term lend here, full legal title passes from the pension fund to the hedge fund, however the lender (pension fund) will retain full economic benefit of owning the shares.
If a dividend payment is made over the life of the agreement, then the borrower (hedge fund) is obliged to pass it back to the lender in what is termed a manufactured dividend.
The same does not occur, however, with voting rights and so lenders need to ensure that under the agreement they are able to recall securities so that they can exercise their vote.
The pension fund runs the risk that the hedge fund doesn’t return the shares as agreed on the termination date. They will therefore ask the hedge fund to provide collateral as a form of security. That way, if the hedge fund does not return the shares (i.e. they default), then the pension fund can use the proceeds from liquidating the collateral to replace the shares in the market.
The collateral that is acceptable to the pension fund is strictly defined in the agreement drawn up between the pension fund and the hedge fund (known as a Global Master Securities Lending Agreement or GMSLA
Acceptable collateral usually constitutes:
Cash
T-Bills
Government Bonds
There is a further risk to the pension fund that the value of the collateral falls between the value date and the termination date and so to guard against this, the pension fund will require a greater amount of collateral than the value of the shares being lent out.
This is known as a haircut.
The value of the collateral will be regularly compared against the market (‘marked to market’) over the life of the loan.
If the value of the collateral falls, the pension fund will ask the hedge fund to provide more by what is known as a collateral call.
If the value of the collateral rises, the hedge fund can request that the pension fund returns the excess amount.
10.6.2: Prime brokerage
The main aim of a hedge fund is to manage investment portfolios on behalf of their client, often employing complex strategies.
So that they can concentrate on these activities, they will often outsource a range of back-office operations to a prime broker.
Prime brokerage services are provided by some of the largest financial services firms such as Goldman Sachs or UBS. Services include custody, securities lending, trade execution and settlement, cash management, and financing for leverage. Let’s look at some of these in more detail.
Custody = Prime brokers will hold the hedge fund’s investments and act as a custodian.
A separate custodian may also be used
Settlement = Trades are ‘given up’ to the prime broker who then settles the trade with the counterparty.
Securities lending = The prime broker will arrange for stocks to be borrowed to cover short positions.
They will also lend out stocks to earn additional income.
Leveraged Financing =
Hedge funds often employ high amounts of leverage.
This means they will borrow several times as much as the value of the fund.
The typical range is between 2:1 and 10:1, but some hedge funds have run leverage as high as 100:1.
A leverage of 2:1 would mean that if the hedge fund had £100 million of assets, they would look to borrow a further £200 million, which they could then use to buy more assets.
This is very risky and so it is unlikely that a bank would be willing to lend them that amount with only the investment portfolio for collateral.
The hedge fund will draw up an agreement with their prime broker, setting borrowing limits and collateral required, which will be monitored on an ongoing basis.
The agreement will likely include a ‘right of rehypothecation’.
This means that the prime broker may use the collateral provided by the hedge fund.
I.e. they could sell it or they could lend it on in either a securities lending or repo transaction, and keep the fee.
Synthetic financing =
Exposure to securities is gained using derivatives instead of physically buying the underlying securities.
As we discovered in chapter 5, this is usually much cheaper than buying the securities outright.
10.7: Corporate Actions (COMMONLY ASKED EXAM QUESUTIONS. particularly calculating theoretical ex rights prices.)
Corporate actions are actions taken by companies that affect its existing shareholders.
There are three categories of corporate action:
Mandatory
Mandatory with options
Voluntary
Mandatory = happens automatically with no action required from shareholder (e.g, dividends being paid)
Mandatory with options (where the action will take place but the shareholder has choices about what to do (rights issues (keep or sell)
Voluntary = where the shareholders decide if the action takes place or not (e.g a takeover bid)
10.7.2: Dividends
As we have seen, dividends are paid to shareholders out of net realised profits. The directors decide on the amount of dividend that is to be paid, and the shareholders get to vote on it at the AGM.
Companies may pay dividends annually, semi-annually or quarterly; they are made up of interim dividends and a final dividend.
Companies paying dividends must follow a strict timetable order, laid down by the LSE, so that shareholders and companies are aware of who is entitled to receive the dividend: (see table)
