Chapter 7: Clearing And Settlement

Question 1

Pre settlement, settlement and post settlement - what occurs at each stage

Answer 1

• Pre-settlement and clearing - trade matching, exchange of counterparty details, checking if the buyer has cash and seller has stock.
• Settlement - the legal ownership of a security is transfered to the buyer and cash is sent to the seller.
• Post settlement - accounts for failed trades etc

Question 2

2 levels of Trade confirmation - comapring counterparty instructions

Answer 2

Occurs at 2 levles
1. counterparties compare details - done bilaterally, by a matchng facility (CSD) or third party central matching system. Electronic order books will have the matching engine software integrated into the system. Centrally cleared transactions clear to a central counterparty
2. Custodians acting on behalf of counterparties comparesettlement instructions.

Question 3

Clearing

Answer 3

= The process where each counterparty’s obligations are legally defined. The process includes:
* Recording trade details to be agreed by counterparties
* formalising legal obligations for counterparties
* matching trade details and agreeing on settlement procedures
* calculate and issue settlement instructions
* Managing and making margin calls when required.

Question 4

Significant central counterparties

Answer 4

• London CLearing house (LCH) - UK
• EquityClear, SwapClear and CDSClear are LCH services across UK and Euronext mkts for specific products
• Deposit Trust and Clearing Corporation (DTCC) - US
• NSCC (equities) and FICC - US - subs of DTCC
• Eurex clearing AG - DEU

Question 5

2 elements of tradde settlement that can differ between assets/mkts

Answer 5

• Timing of settlement
• structure of the settlement system - The Bank of International Settlements (BIS) has 3 settlement models to achieve delivery vs payment (DvP)

Question 6

3 BIS settlement models

Answer 6

1. Transfer instructions and securities/cash (unconditional) at the same time. Done on a trade by trade basis (gross).
2. Delivery of securities occurs during a settlement processing cycle and payment occurs at the end of the processing cycle.
3. Both delivery and payment occur on a net basis at the end of the processing cycle.

Question 7

Delivery vs Payment

Answer 7

Ensures cash from the buyer and securities from the seller are exchanged.

Question 8

BIS model 1 - gross, simultaneous settlement of securities and fund transfer

Answer 8

Simultaneous transfer of instructions, settlement of securities and transfer of funds Makes transfers by book entry
* It debits the seller’s securities account and credits their cash account. The opposite occurs for the buyer.
* Overdrafts for securities are prohibited and cash overdrafts are mostly prohibited.
* Model 1 systems require participants to hold sufficient cash in their account to settle trades as they are unable to adjust cash balances during the settlement cycle
* Model 1 requires enough funds to be held to cover the cost of all debits as well as enough to cover the largest debit balance that is in processing.
* It is very hard to predict what debit balance is required as trades are settled when there are available securities to buy.
* Free of payment trasnfers are allowed
* Use queue mgmt software to try and prevent high fail rates.
* Systems offer automatic cash/securities lending in case trades fail.
* primarily used in EU, Asia - e.g. - CREST in the UK.

Question 9

CREST settlement - UK settlement facility. Settlement process

Answer 9

uses model 1 strucutre
* Settles shares, corp binds and gilts.
* Settles dematerialised shares - all online, no physical share certificates

Settlement process (occurs simultaneously):
* Updates shareholder registry with new owner- updates ‘operator register’
* Issues a payment obligation to the buyers bank requesting cash
* Issues a reciept notification to seller’s bank saying expect payment.

If a CCP is assigned it becomes responsible for settling the trade.
* Allows the option to net settlements to counterparties doing a lot of trades instead of doing 20 individual settlements for example.

Question 10

BIS settlement model 2 - gross settlement of securities followed by net settlement of funds

Answer 10

securities are settled on a gross (trade by trade basis as orders come in throughout the processing cycle and funds are settled on a net basis at the end of the cycle securities accounts are held in the system, funds accounts are held externally by banks.
* Transfers are irrevocable but not final and credit the buyer’s security account and debit the seller’s.
* Funds balances are calculated during the cycle and credits/debits are posted at the end of it.
* Delivery occurs before payment
* Securities overdrafts aren’t allowed by tacit cash overdrafts are.
* Reduced volume of failed transactions as payments are netted, reducing setlement risk as it is easier to guess cash balance to have in your account.
* Using queue software
* Most popular system globally. Big in the US and emerging mkts - S. America, Africa, Middle East.

Question 11

BIS model 3 - simultaneous Net selttlement of securities and funds transfer

Answer 11

simultaneously net settles both securities and transfers instructions.
* Funds accounts held externally by banks. Securities are transferred by book entry (debit buyer, credit seller).
* Running balances of credits and debit are calculated during the processing cycle for both cash and securities and transfers are made at the end of the cycle.
* Trades are only executed if a counterparty has sufficient cash and securities
* Most model 3 systems achive DVP and remove setlement risk from model 2.
* +Reduces the liquidity requirements for funds and cash but - can create huge liquidity exposures if a particiapnt fails to settle it’s net debit position.

Question 12

Role of a custodian

Answer 12

Ensure client’s assets are fully protected at all times.
It must ensure client’s assets remain strcily seperate from the custodian firm’s own assets.

Question 13

4 Types of custodian

Answer 13

• Direct custody arrangements = Custodian is local to the market the investor operates in
• Global custodian = custodian has access to global markets the investor is involved in.
• Central security depositry (CSD) = settles trades and holds securities for each specific mkt
• International CSD (ICSD) = as above but has access to international mkts

Question 14

what is a Sub custodian - how they are selected

Answer 14

Employed by a global custodian to provide custody services in a foreign market. Provides information about it’s local mkt to the global custodian.

Selecting the sub-custodian:
* Global custodians might appoint one of their branches
* Can appoint a local bank specialising in sub-custody services
* Appoint a regional provider that can provide services across a range of mkts in a region

Question 15

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Advantages of local custodians

Answer 15

• Country specialists
• Can be eyes and ears for a global custodian for a specific mkt
• regular dealings with local regulators/politicians so can influence reforms to improve local mkt efficiency
• Expert knowledge of local laws, practices, culture, language etc
• Opportunities for reciprocal business

Question 16

Local custodian

Answer 16

Local market specialists that provide custody services in one specific mkt. Can be advantageous in regions where the laws differ, if the custodian has a good relationship with regulators/political leaders.

Fill a gap in the mkt where bigger custodian firms might find it uneconomical to provide such specific local services.

Reciprocal agreements = The gloabl custodian employs a local custodian to provide local services. In return the gloabl custodian will give the local access th their home mkt.

Question 17

Disadvantages of local custodians

Answer 17

• Credit rating might be below the standard to do business with global custodians
• Cannot leverage tech developments across multiple markets so can be behind technologically.
• might not be able to offer discounts to attract business.

Question 18

Regional custodians - advantages

Answer 18

Provide custody services in a specific region e.g. EMEA, APAC etc.

Advantages
* Higher credit rating than local custodian
* can pass good practices from one mkt to another
* Can leverage tech innovation accross multiple mkts
* standardised reporting across multiple mkts
* Economies of scale = increased efficiency
* Can leverage their size and influence to put pressure on local regulators
* Global clients can secure discounts

Question 19

Regional custodian - disadvantages

Answer 19

• Products might be less tailored to the local environment/culture than a local provider
• The level of service to each individual client might be lower as the firm is focussed across many clients in many regions
• Might lack the track record/customer base of established local custodians

Question 20

Registered title - role of the registrar (at the issuer)

Answer 20

When settling trades, any changes to ownership of securities must be passed on to a company registrar at the issuer. They keep names/company names and legal addresses of all shareholders.

This helps companies keep track of beneficial ownership and who has access to vote in corporate actions. Shareholders can appoint nominees to vote on their behalf whilst remaining the BO of the shares.

Question 21

Nominees

Answer 21

Hold shares in trust of the true UBO but have access to the voting rights of the shares. The shares will appear in the name of the nominee.

Nominees sign a declaration of trust to the shareholder with the agreement that they will hold/return the shares and pay the UBO any dividends.

Firms can employee NOAHs or investment managers to hold securities and act on corporate actions/do admin on their behalf. IMs regularly outsource this responsibility to specialist custodians so are nominees appointing a nominee.

Question 22

Corporate nominees

Answer 22

Issuer of shares offers shareholders the ability to hold their shares in a corporate nominee.

Structured between pooled and designated. Creates a single entity for all shareholders but the issuers registrar is aware of the BOs of each share so can pay seperate dividends to each shareholder.

Question 23

3 types of nominee company and considerations of each

Answer 23

1. Pooled (AKA omnibus/commingled) = individual clients are grouped together with a single nominee registration
2. Designated (AKA numbered accounts) = nominee name includes the unique identifier for each individual client, improves tracking.
3. Sole = specific nominee is used for a speciic client (ABC nominee holdings).

Considerations
* No true security benfit of each
* Shareholders can lose benefits (discounts on products etc) by using nominee accounts
* 2 and 3 offer the ability to wire dividends to a specific client account whereas in 1 this isn’t possible.
* 2 and 3 are easier to audit
* 1 is cheaper to run and administer
* 3 can cause issues for naming convetions due to name ownership rights so can cost the nominee money to name the NOAH/IM.

Question 24

Cum and ex dividends

Answer 24

• Cum dividend = with the dividend - gives the buyer/holder the right to the next dividend payment
• Ex dividend = without dividend = owner does not have the right to the next dividend. occurs periodically

Question 25

Sequence of events leading up to a dividend payment

Answer 25

1. Dividend declared = comoany annouces how much dividend will be paid and on what date usually 2 months prior to payment.
2. Record or books-closed date = a copy of the shareholders registry is taken and the people on the list will recieve the dividend payment. usually friday
3. Ex-dividend date - typically a thursday - 1 biz day before the record date
4. dividend payment = determined by the company and is ususally within 30 days of the record date
5. Ex-dividend period = period from ex dividend date to the dividend payment date is the ex dividend period.

Cum dividend starts again the day before the dividend is paid

Question 26

Considerations for shareholder during ex dividend periods

Answer 26

• If you are buying shares near an ex dividend period, because of T+2 you would have to purchase shares on Wednesday at the latest.
• During ex dividend periods share prices typically fall to reflect the fact new investors won’t recieve a dividend.
• Special cum trade (naughty boy) = investor buys shares in the ex-dividend period but still recieves the dividend
• Dividend payments are exposed to income tax so investor might buy during ex dividend periods to avoid this.
• Disadvantage of special cum and ex trades = dividends might be paid to the wrong person.

Question 27

Continuous Linked Settlement (CLS)

Answer 27

Method most large banks use to manage FX settlement. The process is managed by CLS group holdings (regulated by Fed res. board of NY).

Settles on a payment vs payment basis. The 2 currencies being traded will be exchanged simultaneously.

Before CLS FX trades were made by the counterparty making a payment to the other counterparty creating Herstatt risk (specific form of credit risk).

Question 28

CLS time window and process

Answer 28

CLS operates on a 5 hour windoweach day from 07:00 to 12:00 central european time (CET) and the window overlaps across business days all over the globe, allowing for trading.

Settlement members must submit settlement instructions by 6;30am CET. At 6:30, Each settlement member will recieve a list of the funds that they will be paid that day.

1. 7:00am settlement members send net funds due to settle in each currency to their central bank and CLS will begin settling trades.
2. If criteria are not met on both sides the trade fails.
3. Trades that can be settled - money is paid out by central banks to the counterparty
4. This removes Herstatt risk and achives P vs P

Question 29

Distributed ledger technology

Answer 29

a decentralised network of computers all holding copies of the exact same ledger. Computers in the network are called nodes. Changes to the ledger are done using a consensus
* Can be public or private
* Example is blockchain for bitcoin

Question 30

Advantages of distributed ledger technologies

Answer 30

• Produces a reliable record as all changes require consensus
• Prevent a single failure (e.g. a node breaks) for having a huge impact as the ledger is stored on many nodes holding the valid ledger.
• Very hard to hack as there are so many nodes
• remove costs and delays on updating a single data base

Question 31

Stock borrowing and lending - what is it, why do it

Answer 31

PArty A lends party B securities in return for cash/govt bonds as collateral which are both swapped back at an agreed date.

Main reason to do it
* Securities driven transaction = if a trader requires specific securities temporarily, e.g. to honoour a short position
* Cash driven = lender can increase returns on the securities it holds by lending them out for a fee.

Question 32

Positives of stock lending

Answer 32

• Increase liquidity of the securities mkt by allowing lending which reduces risk of for failed settlements and the penalties associated with this
• Provide extra security to lenders through collateralisation of a loan
• support trading stratergies that are difficult to execute eg derivatives
• Increases investors return by lending their securities
• facillitates hedging and arbitraging of price differentials, improves mkt efficiency

Question 33

Risks of stock lending and what can be done to mitigate the risk

Answer 33

• Failure to return collateral/stock on time
• Manipulate markets by shorting the shit out of things. Stock lending is a key part of short selling.

Mitigation
* Credit check the borrower
* set credit limits on the exposure to a specific borrower
* Collateralise loans against cash or securities
* Mark collateral to market to ensure it’s value truly covers the value of the stock being lent out and do margin calls to accodmodate for any shortfall.
* Use master legal agreements to set out the obligations of both parties and what occurs in the event of a default/systemic crisis.

Collateral taken usually exceeds mkt value of the securities. The % that is exceeds the value is called a haircut and is set before the transaction by the parties.

Question 34

Stock borrowing and lending intermediaries (SBLIs)

Answer 34

A specialist intermediary that takes principal and agent roles in SBL contracts.

The role of the SBLI pooling together securities for large firms has created economies of scale and allows smaller firms to participate in the SBL market.

The owner of the shares being lent and the SBLI willl usually split the revenues at a commercial rate and is determined by many factors like the risk mitigation the SBLI provides etc.

Question 35

Advantages of custodians acting as SBLIs

Answer 35

• Highly competitive market can result infirms making losses, SBLI can boost revenues
• They have an exisiting client base to sell SBL facilities to
• ability to pool funds/assets from smaller underlying funds
• experince in developing and developed mkts
• able to provide indemnities and effectively manage cash collateral.

Question 36

Administration of SBLIs

Answer 36

• Must ensure there is adequate terms and conditions documents issued with counterparties.
• Must ensure they have consent of the owner if the firm lends out their securities. These securities must be kept seperately from the ones that cannot be lent out.
• Consider when collateral should be paid, it’s value, haircuit, type of collateral (cash, govt bonds).
• Check credit worthiness of borrowers
• Cash and assets held as collateral must have all interest, dividends etc paid back to the customer unless it is agreed as part of the rebate agreement

Question 37

Legalities of SBL - 4 reason when SBL is legal

Answer 37

4 reasons that stock lending may be permitted:
* Facillitate settlement of a trade
* Facillitate teh delivery of a short position
* Facilitate a loan to a borrower who is borrowing for one of the above reasons

Question 38

SBL impact on a lender’s rights and corporate actions.

Answer 38

• When on loan - the stock is transfered to the name of the borrower who recieves all dividends and voting rights. borrower must pay dividends back to lender but can vote.
• Corporate actions are typically passed back to the borrower but it is outlined in the securities lending agreement
  *

Question 39

Global master securities lending agreement (GMSLA)

Answer 39

A standardised agreement outlining the terms and conditions of a stock lending agreement between 2 parties. It can have values etc added on to suit the specific agreement but the legal jargon is standardised.

Question 40

Stock lending vs repos

Answer 40

• Stock lenders charge fees to borrowers - repos charge interest to the lender on the cash lent.
• Repos provide secured cash borrowing to a borrower which is cheaper than unsecured borrowing.
• Repos make the lender interest on their cash but reduce credit risk because of the collateral.

Some lenders will be willing to take lower quality collateral in a repo because:
* Lender will typically make better return on higher risk collateral - asset backed securities, corp bonds etc
* High quality collateral is usually in short supply and can be expensive to borrow.

Question 41

Done